Many borrowers use asset-based loans to finance current business needs.
These loans are usually structured by calculating a borrowing base, often as a percentage of eligible inventory and eligible accounts. Depending on the type of inventory, the advance rate ranges from 35 percent to 65 percent for eligible inventory and from 70 percent to 90 percent for eligible accounts.
Recently, lenders have drafted their standard documents to give banks greater discretion in advancing funds on these lines of credit. Boilerplate language inserted in loan agreements can operate to squeeze the borrower’s cash, often at a particularly critical time for the business. Just when your cash needs may increase to deal with a downturn, a lender can utilize provisions in the loan documents to reduce your borrowing capability.
The old adage, “the best time to borrow money is when you don’t need it,” rings true in these instances, and the best time to negotiate these kinds of provisions may be when your business is at its strongest and lenders are competing for your business.
Lenders may squeeze cash in asset-based loans in two fashions. First, the lender often retains an ability to change the advance rate at its sole or reasonable discretion. Reducing the advance rate on a fully extended working line of credit may significantly reduce the borrowing base and therefore the ability of the borrower to draw funds on the line to operate the business.
Second, some lenders insert provisions in the definitions of eligibility of inventory and accounts that further permit the lender to reduce borrowing capability. For example, eligible accounts are often defined to exclude accounts aged more than 90 days, or those subject to offsets or disputes. Many lenders include additional language permitting the exclusion of any account the lender judges to be a credit risk.
Similarly, lenders typically define eligible inventory to exclude inventory that is obsolete or slow-moving. Some lenders include language permitting the exclusion of a wide range of inventory at the lender’s discretion.
Even though a borrower may be in full compliance with all loan covenants and never have missed a payment, a lender, nervous about the company’s financial prospects or leery of a particular industry can reduce loan exposure by changing the eligibility criteria and reducing advance rates. The lender is able to slowly squeeze cash and working capital assets from the borrower while reducing the lender’s exposure on its line of credit. The results for the company can be devastating.
In the extreme, these discretionary features in loan documents may operate more like an agreement to consider loans rather than a loan agreement. Given the expense and impracticality of resorting to litigation, the best practice is to ensure that loan documents are reviewed in detail at the inception of the loan relationship. All parties need to understand how the documents may be interpreted and when, perhaps, to negotiate more objective criteria or look for alternative lenders with less discretionary terms. Marc B. Merklin ([email protected]) is a partner with Brouse McDowell. Reach him at (330) 535-5711.