Loan Documentation The lending process entails some negotiation and results in several documents.
The loan agreement stipulates the terms and conditions under which the lender will loan the firm funds; the security agreement specifies which of the borrower’s assets will be pledged to secure the loan; and the promissory note commits the borrower to repay the loan, even if the assets, when liquidated, do not fully cover the unpaid balance. Pledging Receivables and Inventory Depending on the extent to which they are collectable, lenders may lend as much as 80 to 90 percent of the book value of the receivables.
Asset-based lenders generally are willing to lend against only those receivables due within 90 days and usually less than 100 percent of their value, because they are aware that some portion will not be collectable. Those that are more than 90 days past due are likely to be difficult to collect.
Inventories also are commonly used to provide collateral for leveraged buyout (LBO) transactions. Inventories (raw material, work-in-process, and finished goods), like receivables, can be highly liquid. Lenders generally consider only raw material and finished goods inventories as suitable collateral. The amount a lender will advance against the book value of inventory depends on its ease of identification and its liquidity. Typically, lenders will loan between 50 and 80 percent of the value of inventory and will tend to loan less if the inventory is perishable, is subject to rapid obsolescence, or has relatively few potential buyers.
Pledging Equipment and Real Estate to Support Term Loans A term loan can be structured such that the period of the loan corresponds with the economic life of the item being financed, and borrowers often prefer these loans because there are no concerns about the loan needing to be renewed. Durable equipment and real estate often are used to secure term loans. Lenders are frequently willing to lend up to 80 percent of the appraised value of equipment (but not special-purpose equipment, which is likely to have few potential buyers) and 50 percent of the value of land.
The cash flows generated by the assets will be used to pay off the loan.
Term loans are sometimes used in LBO transactions to reduce the overall cost of borrowing. Because they are negotiated privately between the borrower and lender, they can be much less costly than floating a public debt or stock issue.