When it comes to taking business loans, there are numerous sources of credit for a prospective borrower to consider from, the foremost of which are banks and financial institutions. These organisations are of two types — public and private sector. The fundamental differences between these two kinds of entities largely determine their respective advantages and disadvantages to borrowers.
Private sector financial institutions offer borrowers the benefits of flexibility and speed. However, they’re also comparatively conservative in terms of their risk appetite and set significantly harsher terms than public sector banks. Conversely, while public sector financial institutions often move relatively slower than private sector entities, the terms of debt and ability for larger exposure works in their favour. Given their ‘service to the nation’ motive, they’re mandated to encourage private enterprises, and adopt a more ‘partner’ oriented approach even in times of account irregularity due to business contingencies.
If a borrower decides to opt for a loan from a private sector institution instead of a public sector bank based on one’s specific requirements, then one should consider the following points while negotiating a contract to ensure one’s own interests:
1. Default Accelerations Clause
This clause states that if the borrower fails to pay a specified sum within a stipulated period, the financial institution from which the money was borrowed can demand the immediate return of its principal amount, along with the interest due, effective immediately. The problem lies in the fact that certain clauses may also empower the financial institution to declare a company’s account to be a non-performing asset if it defaults on a payment to another lender, or even if a company to which it is linked (through a clubbed account) fails to honour a loan payment to an unrelated lender. Default Accelerations Clauses safeguard the interests of banks over borrowers, which is why it is essential for any organisation to negotiate to have them removed altogether, if not made extremely specific. This would mean having the agreement cover very precise terms, as opposed to just vague statements that would favour the bank. It would also require limiting the legal authority of the lender to impose penal actions against the borrower, thereby saving the organisation from undue financial and legal burdens in unforeseen circumstances.
2. Conditions Which Affect the Pricing Structure
Rates of interest on loans tend to change over time. If a company takes a loan at a 12% ROI in 2016, by 2018 there’s a fair chance that the company will be able to get the same loan at a 10% ROI, especially if remains profitable and has a strong reputation in the market. Instances like these would naturally temp an organisation to seek a better deal, which is why many lenders have stiff penalties to safeguard their interests in the case of such eventualities.
Furthermore, there may be clauses which state that if the bank perceives any material change in the borrower’s business or business model, they are empowered to increase the rate of interest. If not properly specified, a ‘material change in business’ could be an external, macro-level event, such a change in government regulations, which are out of the borrower’s control and may not even be directly connected to their business. To protect their interests, companies must make sure that such conditions are eliminated or changed to exclude factors beyond their control.
3. Higher Up-front Fees
Many private finance companies charge borrowers high initial consulting fees, security deposits, and initial payments. This is done with the intention of having the borrower spend large amounts of money so as to dissuade them from switching to a cheaper loan when given the opportunity at a later date. To avoid being tied down in such a manner, companies must negotiate to have these initial fees and payments kept to a more reasonable amount.
4. Security Clauses
A security is an asset against which a loan taken. It serves as collateral in case the company defaults on its payments, and serves to allow the lender to recover their money in case of such an eventuality. Most lenders demand collaterals that by far exceed the value of the loan, and in many cases it is in their best interest for the company to forfeit on their payments because the asset is worth significantly more than the loan itself. To avoid risking such high-value assets, it is necessary for borrowers to negotiate more favourable terms.
5. Obscure Clauses
Hidden within various clauses of loan agreements may be points which could severely impact the borrower’s business by empowering the lender to take crucial strategic decisions or mandating their approval on any actions taken by the company. This is regardless of whether or not the borrower is able to make timely interest payments. As a result, the private finance company/bank essentially becomes a co-owner of the organisation, and can severely reduce the flexibility of the organisation and its capacity to take risks. It is of utmost importance that these clauses are removed during the negotiation process.
When taking a loan from a private finance company, it is necessary for the prospective borrower to negotiate to the best of their abilities, using their company’s reputation, innovation, and expertise as leverage to gain as reasonable a deal as possible. Failure to do so would legally and financially trap the company in the clutches of external organisations, and defeat the purpose of taking the loan to begin with. The best advice to those looking to take a loan to advance their business is to read the terms and conditions carefully, because a single line in a single clause could have long-term implications on their company for years to come.
(By Hitesh Asrani, Founder & Director, CRP Risk Management Ltd)