The ABCs of Loan Financing Term Sheets
A loan financing term sheet is a non-binding document that sets out the key terms and conditions agreed upon between a borrower and a lender prior to finalising a loan agreement. It serves as a preliminary agreement for negotiating the final agreement and ensures both parties are aligned on critical aspects of the financing. Below are the essential sections that typically form the foundation of a loan financing term sheet.
Loan Amount
The loan amount is the principal sum that the borrower intends to borrow from the lender. It defines the scale of the financing and aligns the expectations of both parties regarding the financial commitment. The loan amount is determined based on the borrower’s financial needs and the lender’s assessment of the borrower’s creditworthiness.
Interest Rate
The interest rate is the cost of borrowing that the borrower pays to the lender, typically expressed as a percentage of the loan amount. It is one of the most important sections of a loan financing term sheet, as it directly impacts the overall cost of the loan and the borrower’s ability to meet repayment obligations. The interest rate can be either fixed or variable. With a fixed interest rate, the rate remains constant throughout the loan term. In contrast, a variable interest rate fluctuates based on market conditions and is tied to a benchmark rate, such as the Kuala Lumpur Interbank Offered Rate (KLIBOR), Malaysia Overnight Rate (MYOR), or the prime lending rate. A margin is typically added to the benchmark rate. For example, a corporate term loan may have a floating rate tied to 3-month KLIBOR + 2.0%.
Loan Term
The loan term, also known as the loan tenure, refers to the duration over which the borrower is required to repay the loan, typically expressed in months or years. It determines the length of the repayment period, the amount of periodic payments (e.g., monthly, quarterly), and the total cost of borrowing. The loan term is agreed upon by both parties and is usually specified in the loan agreement. It can vary depending on the type of loan, the borrower’s needs, and the financial institution’s policies.
Repayment Schedule
The repayment schedule specifies how often the borrower needs to make payments, which could be monthly, quarterly, or annually, depending on the loan type and agreement. For example, housing loans typically have monthly repayments, while large corporate loans may opt for quarterly repayments to align with their revenue cycles.
Repayments can also be structured in different ways based on the borrower’s needs and the loan type:
Amortised loans: The loan term consists of equal periodic payments, with each payment covering both principal and interest.
Balloon payments: The borrower makes smaller periodic payments during the loan term and pays off a large lump sum (the “balloon payment”) at the end of the loan term. This structure is often used for commercial property financing, where cash flows are expected to improve significantly over time.
Bullet repayment: The borrower repays the entire principal at the end of the loan term, with periodic payments covering only the interest during the loan term.
Collateral
Collateral refers to an asset or a portfolio of assets pledged by a borrower as security for a loan. It serves as protection for the lender, if the borrower defaults on the loan, the lender can seize and sell the collateral to recover the outstanding debt. Collateral mitigates the lender’s risk and can influence the terms of the loan, including the interest rate, loan amount, and loan tenure. It may consist of various assets, such as real estate, vehicles, financial assets, and inventory.
Covenants
Covenants are legally binding clauses included in a loan agreement that specify the conditions, obligations, and restrictions the borrower must adhere to throughout the loan tenure. They are designed to protect the lender’s interests by ensuring that the borrower maintains financial stability and minimises risks that could affect loan repayment. Covenants can be categorised as follows:
Positive Covenants: These outline actions the borrower is required to perform to ensure compliance with the loan agreement, such as maintaining adequate insurance coverage for pledged assets.
Negative Covenants: These specify actions the borrower is prohibited from taking to prevent an increase in financial risk or a reduction in the lender's ability to recover the loan. For example, the borrower may be restricted from taking on additional debt without the lender’s approval.
Financial Covenants: These require the borrower to meet specific financial metrics or ratios to ensure financial health and stability, such as maintaining a minimum interest coverage ratio.
Fees and Expenses
The fees and expenses section of a loan term sheet defines the costs involved in securing and managing the loan. This section is essential for both borrowers and lenders, as it outlines the financial obligations beyond the loan’s principal and interest. Typical fees and expenses include origination fees, processing fees, and legal fees, along with details on which party is responsible for covering these costs.
Conditions Precedent
Conditions precedent are requirements that must be met before the loan agreement can be finalised and the loan proceeds disbursed. These conditions are put in place to ensure that specific criteria are fulfilled to mitigate risks for the lender. They serve to protect the lender by confirming that the borrower is adequately prepared to take on the loan and that all necessary documentation and approvals are in order. These conditions may include submitting required documents, obtaining regulatory approvals, or meeting specified financial covenants.
Default and Remedies
The default and remedies section defines the circumstances under which a borrower would be considered in default and outlines the actions the lender can take if the borrower fails to meet the loan agreement’s terms. This section is important for both parties, as it establishes the consequences of non-compliance and provides a clear process for addressing any issues during the loan period. It safeguards the lender’s interests by specifying potential default triggers and detailing the available remedies. Defaults may include missed payments or breaches of covenants, while the lender’s remedies may involve accelerating the loan (demanding full repayment) or seizing collateral.
Ringfencing of Proceeds
The ringfencing of proceeds refers to a provision that restricts or specifies how the borrower can use the funds obtained from the loan. It involves segregating the loan proceeds for specific uses, serving as a risk management tool for lenders to ensure that the funds are used only for the purposes aligned with the original intention of the loan, rather than being diverted to other activities. This section is particularly important when the lender wants to protect their investment and ensure that the borrowed funds are used in a way that will generate sufficient returns or enable the borrower to meet repayment obligations. In the Malaysian market, ringfencing of proceeds is commonly seen in sectors such as project financing, real estate development, and structured finance. For example, in infrastructure projects, proceeds are often ringfenced to ensure they are used solely for construction and development phases, with strict monitoring and reporting obligations in place.
Governing Law
The governing law specifies which jurisdiction’s legal system will apply to the loan agreement. This provision defines the legal framework for resolving any disputes that may arise in relation to the loan. It is important for both the borrower and the lender, as it ensures that both parties understand the legal context in which the loan is governed.
Conclusion
A loan financing term sheet is a critical document that sets the foundation for the final loan agreement. By outlining the essential terms and conditions in advance, it provides both parties with a clear understanding of their obligations and expectations. This clarity helps reduce potential conflicts and ensures the loan agreement is structured to meet both the borrower’s and lender’s needs. Through careful negotiation and consideration of these key sections, both parties can enter into a loan agreement that is fair, balanced, and aligned with their respective financial goals.
