EDITOR’S NOTE: Commercial Finance 701 is a continuing series on commercial loans written exclusively for the Mississippi Business Journal. This series is geared to lenders, developers, investors and transactional attorneys.
In commercial finance, the difference between a term sheet and a commitment letter is like the difference between a football prospect’s “soft commitment” and an executed National Letter of Intent. They both are beneficial and significant – but they are not the same.
A term sheet is a bank’s non-binding letter of intent, an indication of proposed loan terms for a particular loan. The issuance of a term sheet signifies the bank’s genuine interest in the loan, but without a commitment by the bank. If subsequent due diligence and underwriting are satisfactory, the term sheet may convert to a commitment. Term sheets are usually “for discussion purposes only,” subject to approval of a credit committee, and often not signed by either party. In contrast, a fully executed commitment letter is a confidential, binding obligation of lender and borrower to close a loan on stated terms.
UNIFORMITY IS NOT THE RULE
Some banks issue term sheets to start the negotiations and then, once the details are resolved, follow with a commitment letter. Most banks, however, skip the term sheet and go straight to a commitment letter. Still, others provide a term sheet and then move directly to closing, completely skipping the commitment letter stage altogether. In these instances, the borrower is spending time and money without the bank’s commitment. Finally, and confusingly, a few banks will issue a term sheet – which doesn’t bind the bank – but have the borrower commit to the arrangement even though the bank remains obligation-free.
The form and content of these documents vary widely among banks, but most borrowers’ eyes go straight to the LOAN AMOUNT and the INTEREST RATE. Then, the borrower moves on to consider the FEES, the MONTHLY PAYMENT, and the MATURITY DATE.
The loan amount is not always stated as a fixed number. In a line of credit, there will be an upper limit, subject to a borrowing base calculation that takes into consideration some percentage of assets (oftentimes receivables or inventory). In construction loans, the loan amount might be stated as the lesser of the contemplated loan amount or a percentage of value based on a yet-to-be obtained appraisal. The percentages of value (“loan to value”) may be capped by federal regulators. As an example, the U.S. Comptroller of the Currency restricts national banks from making commercial real estate construction loans with LTV ratios greater than 80 percent.
Although you can still get a fixed rate on loans for shorter periods, variable rates are the norm. The interest rate quote might be, for instance, 30-day LIBOR plus 350 basis points (about 3.7 percent at today’s rates) but with a floor – say 4.5 percent. Sometimes, the quote might provide a choice – say the variable rate or a 5.5 percent fixed rate for three years.
A standard fee on a commercial loan is 1 percent of the loan amount. Depending on a host of factors (net worth, collateral, guaranties, loan type, interest rate, relationship, etc.) the fee may be reduced or waived… or doubled. The fee is sometimes split between the signing of the commitment letter (a “commitment” fee) and the closing of the loan (an “origination” fee).
Monthly payments of principal and interest are common. Lines of credit, however, tend to be interest-only until maturity (absent a decline in the “borrowing base”), and a construction loan might require only interest payments through completion and “ramp up.”
Maturities vary based on loan types. Lines of credit tend to be between 1 -3 years. Construction loans might be 3-5 years and include a 2-year interest-only construction period followed by a 3-year “mini-perm” period with principal and interest payments based on a longer amortization period. A term loan might go out to 7 years. Extended maturity dates avoid – or at least delay – subsequent closing costs and updated appraisals.
At the risk of sounding like attorneys, the rest of the commitment letter is important. Yes, the interest rate is important, but sometimes — like the price of gasoline — a little deviation in the pricing receives too much attention. The urge to get the “lowest rate” ignores the overall “cost” of the transaction. Guaranties. Equity. Minimum balances. Appraisal. Survey. Inspections. Environmental Phase I. Audits. Financial reporting. Title insurance. Attorney fees. It is quite possible the lowest interest rate proposal is not the best proposal.
For the borrower interested in obtaining the overall best and lowest cost commitment, there is a tried and proven method. SELL the lender on your idea – not on the phone or over lunch but on paper. You will need:
1. a written business plan
2. proforma financial statements
3. sources and uses statement
4. project cost estimates
5. entity structure and ownership
The goal is to win the loan officer over with DETAILS. Nothing impresses a loan officer (and the very important credit officer hiding in the back room) more than a well-written business plan covering all the issues.
Once the commitment letter is signed, the borrower can expedite the loan closing process and lower closing costs by being organized and diligent. Deliver early. Prompt delivery of due diligence items to a loan officer or closing attorney will result in a smile, expedited closing and reduced legal fees.
» Ben Williams and Molly Jeffcoat Moody are attorneys in a commercial law practice at Watkins & Eager PLLC (watkinseager.com). Ben is recognized by Chambers USA and Best Lawyers in America and was selected as Best Lawyer’s 2014 Commercial Finance Lawyer of the Year in Jackson. Molly is recognized by Chambers USA in the area of Real Estate Law.