Many small, medium and startup businesses will need to borrow money through traditional banks or venture capital firms. This can often be a confusing time for many business owners who will be faced with financial term sheets or offers to finance. This article provides introductory information for small, medium and startup business owners who are faced with the need to obtain debt financing.
What Is a “Term Sheet”?
A term sheet (which may be also called an offer to finance or a loan or credit agreement) is a document that outlines the terms upon which a lender, such as a bank, venture capital firm or other financier, will extend credit facilities to you or your business. A term sheet will typically outline the main lending provisions that will govern the loan being made – these include, among other things, interest rate, amortization and repayment schedule, security requirements, reporting requirements, positive covenants (i.e. things you must do) and negative covenants (i.e. things you must not do).
Is a Term Sheet Legally Binding?
In the context of a lending transaction, a term sheet may be either (i) a legally binding agreement between the parties (these are often called offers to finance or credit or loan agreements) or (ii) a non-binding expression of interest (which, if executed by the parties, will lead into a more fulsome and legally binding credit agreement). It is important to carefully review all term sheets to determine what obligations (if any) it creates on you and the lender.
Typically, a legally binding term sheet will set forth the conditions upon which the lender will extend the credit facilities to your business – these are normally referred to as the conditions precedent. If the conditions precedent are not satisfied (usually before a specified funding deadline), the lender will not be required to advance funds. In such an event, there may also be “break fees” or other penalties, and you may be responsible for paying all of the lender’s costs to date (including the lender’s legal fees).
When seeking financing, entrepreneurs and small business owners should be aware of the provisions of a term sheet prior to signing and agreeing to borrow funds.
What Can Be Included in a Term Sheet?
There are many provisions that may be included in a term sheet or credit agreement. These may include:
- Repayment and Prepayment Provisions – It goes without saying that it is fundamentally important to fully understand the repayment schedule for your loan (Are there any “balloon” payments you need to plan for? Does the term sheet contemplate a “cash sweep”), as well as any penalties or charges for prepayment. These may affect how you carry on business going forward;
- Conditions Precedent – These are the things you must do before the lender will advance any funds. Conditions precedent typically include the satisfactory completion and registration of security (which likely includes a solicitor’s opinion), but may also involve delivery of appraisals, real property reports, satisfactory phase I and/or phase II environmental reports, and many other things. It is crucial to understand what conditions you are agreeing to satisfy before you sign the term sheet;
- Security – This is a listing of the security the lender will obtain from you (and/or from related entities/individuals) in order to secure repayment by you of the loan. You need to be sure you can provide this security and should consider things like (i) Have you already agreed to grant security to another lender (perhaps a vendor financer) over any of your assets? (ii) Are any third party consents required (this may be relevant if you are mortgaging a lease of real property or if you are pledging shares)? or (iii) Is your ability to repay other debt (for example, to shareholders or to a vendor financer) restricted or postponed?
- Positive and Negative Covenants – These typically set out a listing of things you must do to avoid default (paying taxes, reporting with financial statements, satisfying certain financial covenants) and things you must not do (paying dividends, repaying shareholder loans, and so forth). These items can affect how you conduct your business from day to day and should be considered prior to signing.
Although there may be a wide variety of provisions included in term sheets, it is critical for all business owners to know what they are agreeing to prior to signing a term sheet.
Regardless of how your business obtains financing, you should be aware of the many common legal and business issues that may arise when signing term sheets or offers to finance, including:
- When should you engage a lawyer?
- What important business terms should be included in the term sheet?
- What positive covenants exist in the term sheet?
- What negative covenants exist in the term sheet?
- What interplay exists when there are multiple lenders?