For a start-up enterprise or an enterprise planning for a growth phase, timely access to funds can prove to be one of the main vehicles for success. It is also in the best interest of an enterprise wishing to finance its operating activities or acquisitions to find financing that meets its needs at an acceptable cost. To do so, an entrepreneur can call upon a multitude of potential sources of financing available, including, in particular, personal investments, investments by family or friends, venture capital, grants or loans from financial institutions.
Among these sources, financing from financial institutions is the preferred method for most SMEs. In this respect, according to the Canadian Bankers Association, banks alone provide approximately 58 % of small business financing in Canada.1
REQUEST FOR FINANCING
An enterprise that desires a loan from a financial institution must be in a position to reassure of the associated financial risks. Thus, at the first meeting stage, the representative of the financial institution should be presented with a detailed business plan that describes the enterprise's activities as well as the realistic financial projections. Furthermore, financial statements for the previous financial years may also allow the investors to evaluate certain key ratios, including, in particular, profitability ratios, cash ratios and capital structure ratios.
Situations may arise in which a young enterprise certainly exhibits excellent prospects of profitability, however, it is doing business in an industry that presents a high risk of losses or it does not have sufficient security to offer 2. Given that one of the main decision-making criteria of traditional financial institutions is whether the borrower will remain a viable enterprise, in such situations, it may be that certain specialized financial institutions, such as asset based lenders, subordinated lenders or certain governmental institutions, will better meet the borrower's particular needs.
OFFER LETTER
The next step consists in negotiating and entering into a letter of offer. This document sets out the type of loan and the applicable terms as well as all of the conditions that must be satisfied before the financial institution will disburse the funds.
Within these conditions, the financial institution usually wants to ensure that it will be able to perform a due diligence review of the borrower so as to subsequently put into place sufficient security on the borrower's assets, obtain guarantees from the appropriate persons, obtain the necessary consents from persons having an interest and, ultimately, put in place all legal agreements or documents useful in protecting its interests.
DUE DILIGENCE
Due diligence is the process whereby a lender undertakes to validate certain declarations made by the borrower as well as certain facts in order to be in a position to better assess the risks related to its loan. Obviously, various factual and commercial elements may cause the scope of the verifications to vary.
Among the various potential verifications, particular attention is given to the collecting of information regarding the financial strength of the borrower and other relevant persons related to the borrower. In this context, many verifications will be made at a multitude of data banks including, in particular, those maintained by rating agencies, the Office of the Superintendent of Bankruptcy, the clerks of various courts, judicial and administrative tribunals, and even tax authorities.
The lender will also want to ensure the legal capacity of the borrower to enter into the loan transaction as well as the validity of the borrower's consent to its obligations. For example, in the case of a corporation, various verifications of a corporate nature will be required to ensure that the corporation is validly existing and is in conformity with its corporate organization. In particular, the lender will review the corporation's articles, by-laws, corporate records, any shareholder agreements that may exist, and the resolutions authorizing the planned financing. Therefore, it is important that your corporation's minute books are up-to-date and all annual filings under corporate laws must have been made in order to avoid delays and additional costs.
The nature of the borrower's activities could, at times, also require that certain permits or authorizations be obtained from third parties. In such circumstances, certain verifications must be made to ensure that the borrower's commercial activities are not being carried out in breach of its industry's applicable regulations or in breach of certain agreements made with its main partners.
Furthermore, the borrower's assets that are offered as security will also be the subject of certain verifications, including, in particular, as regards to ownership as well as to any security already charged against such assets. In this regard, verifications must be made in the various relevant registers. For example, in Quebec, such verifications will be made at the Register of Personal and Movable Real Rights, the land register, the register of security created under section 427 of the Bank Act and the various databases maintained by the Canadian Intellectual Property Office. In addition, depending on the nature of the given assets, additional verifications may also be required; in particular, where immovable property is involved.
NEGOTIATION OF THE FINAL AGREEMENTS AND DISBURSEMENT
According to the terms set forth in the letter of offer and in light of the results of the due diligence, the lender and its legal counsel will draft the legal documents, including the key document, the loan agreement, which sets out all the financial and legal terms and conditions. In certain cases, if the letter of offer is sufficiently detailed, it may itself serve as the loan agreement, thereby avoiding the expense of drafting a separate loan agreement.
The next step will be to put in place the security agreements that will serve to guarantee the repayment of the loan if the borrower defaults. These agreements may take many different forms; they could include an undertaking by a person, such as a personal guarantee, or the charging of an asset, for example by means of a hypothec or a pledge, to guarantee fulfilment of the borrower's obligations. The form of each security will also vary depending on the nature of the asset being charged as well as the geographical location of the asset or person concerned.
The accessibility and accuracy of the information required by the financial institution's legal counsel to prepare this legal documentation will significantly affect the efficiency and cost of this process. In practice, many circumstances may complicate, or even jeopardize, a financing, including, in particular, the existence of undisclosed potential liabilities, the absence of cooperation on the part of an existing lender, questionable title to property or rights to assets, or any other situation that may alter the financial institution's perception regarding its risk.
CONCLUSION
An enterprise that has its legal affairs in good order has all the more chance to see its financing put in place within the estimated schedule and budget. In addition, financial institutions are interested in doing business with enterprises that are in a position to demonstrate that the necessary financial and legal measures have been taken to minimize the risks associated with the desired loan. Experience shows that an entrepreneur has every interest in being proactive and engaging the services of advisors in this regard well before undertaking the process of obtaining funds, as this will avoid delays and extra costs when the time comes.
Footnotes
1 See: http://www.cba.ca/en/media-room/50-backgrounders-on-banking-issues/122-contributing-to-the-economy.
2 The nature or particularities of certain assets provided to a financial institution as security can in some instances negatively affect their potential value. For example, although intellectual property, such as trademark, copyrights or patents, certainly have a value when they are used in carrying on an enterprise's business, they generally do not have the same value from the point of view of a financial institution in the event that it must realize on its security by liquidating these types of assets.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
