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Online Small Business Workshop

 

 

 

Last Edited
April 14, 2003

 

 

ONLINE SMALL BUSINESS WORKSHOP
> Long Term Debt Financing

Characteristics of a Term Loan
Types of Loan Security Agreements
Approaching Long Term Debt Lenders

Characteristics of a Term Loan
"Term" refers to the time for which money (a secured loan) is required and the period over which the loan repayment is scheduled. A long term loan is arranged when the scheduled repayment of the loan and the estimated useful life of the assets purchased (e.g. building, land, machinery, computers, equipment, shelving, etc.) is expected to exceed one year. Long term loans are normally secured, first, by the new asset(s) purchased (up to 65%) and then by other unencumbered physical assets of the business (for the remaining 35%) , or failing that, from additional funds from shareholders or personal guarantees from the principals. On the balance sheet, the equipment purchased shows up in the long term assets section, while the counterpart loan information is shown in the current and long term liabilities portions. The useful life of the assets is directly reflected in their depreciation schedules.

Debt lenders (creditors) make loans to businesses that exhibit strong management ability and steady growth potential. A written business plan, including a cash flow demonstrating the business' ability to repay the loan principal and interest over the term of the repayment schedule, is mandatory. The lender will expect you to have appropriate insurance to protect the assets.

Characteristics: Principal repaid over a period of time directly related to the useful life of the asset(s) (e.g. land and buildings - up to 30 years, computers - 3 years).

A loan carries both interest and principal repayment provisions in a set repayment schedule. Early repayment may entail a penalty because the lender had not planned an alternate investment for that money.

The percentage interest rate normally remains constant for the term of the loan. Each payment of principal reduces the balance of principal remaining and the subsequent interest is calculated on this reducing balance.

Different lenders make different types of term loans. Term loans often carry lower interest rates than operating loans because the term is fixed and the loans are secured by assets (asset-backed).

Types of Loan Security Agreements

Promissory Note: A promissory note is a written promise to pay a specified sum of money to the lender either on demand or on a specified date.

Realty Mortgage: The realty mortgage is a loan (mortgage) whose proceeds are applied to the purchase or re-finance of land and buildings. A charge against the title is registered with the Province.

Chattel Mortgage: The chattel mortgage is a mortgage on specific assets other than land and buildings. A lien charge against the title is registered with the Province.

Pledge: The pledge is an agreement similar to the chattel mortgage, except in that possession is transferred to the lender but title remains with the borrower, e.g., your stocks and bonds held by the bank.

Floating Charge: The floating charge is an agreement which designates that all the remaining assets in the business, not already mortgaged as security for other debts, will be taken as the security for the new debt. The title remains with you but a debenture is registered with the Province.

Personal Guarantee: This agreement says you will agree that if the limited company is unable to repay the loan, you will do so personally. If this is in addition to other securities, you would be wise to try to negotiate a limited guarantee to cover the shortfall in the security for the loan. Try also to recover your personal guarantee as soon as the business has paid off its obligation or can carry the debt on its own security. That personal guarantee places those things you and your family hold dear at risk for the debts of the business.

Postponement of a Claim:The Postponement of a Claim allows the lender to ask for assurance that the company will not repay the shareholders until the secured lenders have been repaid in full.

Approaching Long Term Debt Lenders

The predictability of repayment and degree of control over loan security makes the asset-based long term loan the preferred investment of most lenders and lending institutions. Provided that the equity requirement, leverage factors and asset-based security is adequate, a variety of lenders can be found to conclude these loan agreements.

These long term debt financing sources can be divided again into the sub-categories of:

  • Mortgage Lenders
  • Term Loan Lenders
  • Equipment Finance/Leasing Lenders.

Most people approach the subject of borrowing money with some trepidation. You should never view borrowing money from a commercial loan institution as begging for money. Rather, consider that you are offering the financial institution an opportunity to do business with you -to make a sale.

You will be renting money from people who, in turn, are soliciting your business. Banks, credit unions, finance companies and others need your business to make their money work for them. Loans are just another commodity on a retailer's shelves, and it becomes your challenge, in conjunction with the loans officer, to find the one that best fits your circumstances.

The Loan Officer's job is to rent money at profitable rates of interest with a minimum of risk. The loans officer needs to feel comfortable that he/she has recommended an astute investment, predicated on tested principles of lending (business plan with financials from which ratios can be developed), when your case is presented by the officer to the bank's loan review board.

Mortgage Lenders
The institutional providers of first level mortgage lending include the Insurance Companies, the Banks, the Trust Companies and the Pension Funds. There are also long term mortgage loan financiers to be found in the private sector. The twenty-five year long term mortgage though, has largely disappeared; a maximum five year term reflects the character of today's long term mortgages. Many of these smaller private mortgage financiers advertise their services aggressively, especially where those offerings relate to mortgage extensions on property in strong real estate markets (such as the Lower Mainland market).

A first mortgage will earn the lender approximately 12% interest, a second mortgage, 15%, and a third mortgage, 18% - 20%. These lenders can be easily located and your approach to them assisted (or prepared for you for a fee) through consultants known as mortgage brokers (provincially licensed and bonded).

Approaching the Sources of Mortgage Financing:
Mortgage financiers must normally be approached with a prepared proposal, which will be judged on the basis of who the borrower is (i.e. personal financials); the type of building and its use; the location of the property; its condition of repair; its value established by professional appraisal, comparative sales, cost and income; the company balance sheet; and the projected or actual cash flow. Again this approach can be prepared for you by contacting a provincially licensed and bonded mortgage broker.

(Long) Term Loan Lenders
The providers of basic long term loans include the Banks, the Trust Companies, the Insurance Companies, the Pension Funds and various Loan Specialists.

Approaching Sources of Long Term Loan Financing:
Term loan evaluation tends to be more rigorous and sophisticated than mortgage loan evaluation. In summary, this lender is evaluating the abilities of the management team, the collateral available to support the loan and the commercial viability of the situation, as indicated in the projected financial submissions.

This evaluation will normally require a detailed business plan (in a bound presentation format) which provides extensive information on the management of the company or project; a detailed history of the business, its products, its production methods, its operations, its position in the marketplace; the purpose for which the loan is intended (in intimate detail); any security available to be pledged; and extensive financial information and projections.

Assistance to prepare this presentation can be accessed through the Management Services arm of your local Business Development Bank of Canada or the Start-Up Centre of the Canada / British Columbia Business Services Society.

Equipment Financing/Leasing Lenders
The providers of term loans to finance equipment include the Banks, the Trust Companies, the Insurance Companies, the independent sales finance companies and, on occasion, the equipment vendors themselves.

Note: Equipment purchase is an eligible activity under the terms of the Small Business Loans Act, a program of the Government of Canada, which can be requested to provide a guarantee to the financial institution to allay a portion of the risk of the Small Business Improvement Loan (SBIL). Information on this is available from your local commercial bank, or the Canada/British Columbia Business Services Society.

Approaching Sources of Equipment Financing/Leasing Lenders:
These financiers (the commercial banks, the trust companies, the credit unions) look for many of the same proofs of commercial viability that the Long Term Loan people require. Again, a bound business plan is in order. Remember to make the financial information in the plan easy to locate. The role of the loans officer in the commercial banks is to prepare a loan summary report from your information, which will be submitted to his or her loan supervisor with the officer's recommendation to support or reject. These financiers are eligible under the SBIL program loan guarantee.

If the purpose of the business plan is primarily to procure the capital financing to purchase an expensive new piece of machinery or to upgrade an existing production line, include a dual scenario financial argument. One full set of financial projections should be provided utilizing the existing numbers and the current equipment situation (balance sheet, cash flow and income statement). A second full set of financial projections should cover the same period of time and show the situation as if the new equipment were in place (balance sheet, cash flow and income statement).

Include an expectation of the useful economic life of the new equipment and resale value over the course of its useful life.

The Business Development Bank of Canada (ineligible for the SBIL Loan Guarantee Program) is also a key lender when it comes to equipment purchases and fixed asset acquisitions in general. While the BDBC does not offer discounted interest rates, it can choose to schedule the repayment over a longer term than the commercial banks.

Sales finance companies, in cooperation with the equipment suppliers (vendors) commonly offer sales finance programs and lease-back options on their equipment. The onus is upon you to ask your vendor if he/she has access to any such finance programs, or if the vendor will finance the purchase directly.

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