Structuring a commercial loan need not be a daunting task. In simple terms, the structure is generally determined by the purpose of the loan, the borrower's ability to repay, and the useful life of the assets purchased with the loan. Commercial loans have many different forms and names, but generally can be categorized into three types: those with a short-, medium, or long-term purpose.
Lines of Credit
Perhaps your business is seasonal and you're in need of working capital. A line of credit is extended for short-term purposes requiring that you repay the loan from the revenues generated by that capital. For example, credit is extended to a farmer who buys seed and chemicals, raises a crop, and repays the lender from sale of the crop at year's end. Another example would be financing the purchase of inventory or the fabrication of products that are seasonal in demand. The lender is, in effect, betting that the anticipated sales will occur and that accounts receivable will be collected to repay the lender. Lines of credit also might be used to advance the cost of labor and materials to a borrower who is contractually reimbursed at specific stages during the building or fabrication process.
Lines of credit can be used as permanent capital loans; a substitute for equity. Such loans constitute revolving credit - the loan is never fully paid, but continually has advances and repayments. These loans are typically secured by accounts receivable and inventory. These loans are generally used if a business has little or no seasonality, and has the continual need to meet short-term expenses while collecting accounts receivable or maintaining a certain inventory level.
Bridge loans are similar to lines of credit in that they are short-term. The credit serves as a bridge until a certain specified event occurs that creates the ability to repay. The event triggering repayment could be the sale of an asset, an infusion of equity or pre-arranged refinancing of the debt, as when an interim construction loan is replaced with permanent financing.
If the purpose of the loan is to purchase assets that decrease in value over time, such as machinery or equipment, you should repay the loan before the asset has to be replaced. Thus, if the asset will be obsolete seven years from now, the term of the loan will typically be less than seven years. At a minimum, the loan will be collateralized by the asset being purchased, so the lender will also be concerned with whether the liquidation value of the asset will exceed the outstanding balance of the loan at any given time.
Term loans may be given for other purposes, such as providing long-term working capital to expand, hire additional employees, or do additional marketing. The lender, like the borrower, is betting that such expenditures ultimately will result in additional revenue that can be used to repay the loan. However, the return from such expenditures may take years to materialize, so low monthly payments provide cash flow relief while the revenue builds. Loans of this type typically are amortized over seven years or less. Since term loans are repaid from cash flow from operations, the lender will evaluate the borrower's long-term profit potential.
If you're looking to purchase land or buildings, or to finance construction of a facility or to improve existing facilities, the loan repayment period is usually 20 years and the loan is secured by the asset being purchased or existing assets. If the asset is being constructed, you may generally pay interest only until construction is completed. Alternatively, you may also establish a shorter-term bridge loan, and pay it off with a permanent mortgage loan when construction is completed.
Work with your Lender
A sensible loan should be profitable for both the borrower and lender. Work with your lender to structure financing that takes into account your ability to repay, cash flow, and asset values. Your lender should be as motivated as you are to structure loans that are prudent, while maximizing the profitability of your business.
Updated: January 1, 2013
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service or as a determination that any investment strategy is suitable for a specific investor. Investors should seek financial advice regarding the suitability of any investment strategy based on their objectives, financial situations, and particular needs. This article is not designed or intended to provide financial, tax, legal, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought.
© 2013 Wilmington Trust Corporation.