14: Long-Term Debt and Leasingloans over publicly traded debt is their flexibility. The securities (bonds or notes) in a public debt issue
are usually purchased by many different investors, so it is almost impossible to alter the terms of the
borrowing agreement should new business conditions make such changes desirable. With a term loan,
the borrower can negotiate with a single lender for modifications to the borrowing agreement.^2
Characteristics of Term Loan Agreements
The actual term loan agreement is a formal contract ranging from a few to a few hundred pages. The
following items commonly appear in the document: the amount and maturity of the loan; payment dates;
interest rate; positive and negative covenants; collateral (if any); purpose of the loan; action to be taken
in the event the agreement is violated; and share purchase warrants. Of these, payment dates, collateral
requirements and share purchase warrants require some discussion.
Payment Dates
Term loan agreements usually specify whether the loan payments are made monthly, quarterly or
annually. Generally, these equal payments fully repay the interest and principal over the life of the loan.
Occasionally, a term loan agreement will require periodic interest payments over the life of the loan
followed by a large lump-sum payment at maturity. This so-called balloon payment pays back the entire
loan principal if the periodic payments represent only interest.
Collateral Requirements
Term lending arrangements may be unsecured or secured. Secured loans have specific assets pledged
as collateral. The collateral often takes the form of an asset such as machinery and equipment, plant,
inventory, pledges of accounts receivable and pledges of securities. Unsecured loans are obtained without
pledging specific assets as collateral. Whether lenders require collateral depends in part on the lender’s
evaluation of the borrower’s financial condition.
Term lending is often referred to as asset-backed lending, although term lenders, in reality, are primarily
cash flow lenders. They hope and expect to be repaid out of cash flow, but require collateral both as an
alternative source of repayment and as ransom to decrease the incentive of borrowing companies to
default (because a defaulting borrower would lose the use of valuable corporate assets). Most pledged
assets are secured by a lien, which is a legal contract specifying under what conditions the lender can take
title to the asset if the loan is not repaid, and prohibiting the borrowing company from selling or disposing
of the asset without the lender’s consent. Liens serve two purposes: to establish clearly the lender’s right
to seize and liquidate collateral if the borrower defaults; and to serve notice to subsequent lenders of a
prior claim on the asset(s). Not all assets can be readily used as collateral, of course. For an asset to be
useful as collateral, it should: (1) be non-perishable; (2) be relatively homogeneous in quality; (3) have
a high value relative to its physical size; and (4) have a well-established secondary market where seized
assets can be turned into cash without a severe price penalty.
Share Purchase Warrants
The corporate borrower sometimes gives the lender certain financial benefits, usually share purchase
warrants, in addition to the payment of interest and repayment of principal. Warrants are instruments that
balloon payment
A large lump-sum payment
that pays back the entire loan
principal at the maturity of a
term loan that during its life
requires only periodic interest
payments
collateral
The specific assets pledged to
secure a loanlien
A legal contract specifying
under what conditions a
lender can take title to an
asset if a loan is not repaid
and prohibiting the borrowing
company from selling or
disposing of the asset without
the lender’s consentshare purchase warrants
Instruments that give their
holder the right to purchase a
certain number of a company’s
ordinary shares at a specified
price during a certain period
of time2 Companies typically arrange loans with commercial banks as part of a larger, ongoing banking relationship. Large companies often have
dozens of these banking relationships, but a critical decision for smaller companies is whether to maintain one large banking relationship or
several smaller ones in order to minimise the risk of being unable to arrange financing during an emergency.