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Debt financing offers business owners a strategic avenue to secure capital for growth, operations, or expansion by borrowing funds from lenders. Unlike equity financing, which involves giving up ownership stakes, debt financing allows businesses to maintain complete control while accessing necessary funds. Whether through traditional bank loans, lines of credit, or bonds, this method provides flexibility in repayment terms and interest rates tailored to the company’s financial needs. This blog will highlight the important concepts and transactions involved in debt financing.

The Basics of Debt Financing

In essence, debt financing is where a party, typically referred to as a creditor, provides financing to another party, the debtor. The debtor must repay the funding to the creditor through specific terms agreed to between them.

The debt may be secured or unsecured. Secured debt is backed by collateral, which is an asset pledged by the debtor to the creditor as security against the loan. If the debtor defaults, the creditor can seize the collateral to recover the outstanding debt. Common examples include mortgages (where the home serves as collateral) and auto loans (where the vehicle is collateral). Unsecured debt, on the other hand, does not require collateral. Instead, creditors rely solely on the debtor’s creditworthiness and promise to repay. Examples include credit cards, personal loans, and student loans.

The Initial Agreement Between the Parties

The process typically begins with the debtor agreeing to provide financing to the creditor under the terms and conditions offered in an initial agreement. The style and form of this letter can vary and can be named a commitment letter, an offer to finance, a term sheet, and more. However, such an agreement generally contains the following features:

  • The types of financial accommodations offered to the debtor and the rate of interest applicable;
  • The type of credit or credit facilities which provide access to funds through options such as lines of credit, credit cards, overdrafts, term loans, and trade finance;
  • The maximum credit available per credit facility;
  • Repayment terms, including a maturity date for the loan;
  • The fees associated with using the debtor’s services; and
  • The security required for the loan.

A loan agreement often replaces the commitment letter, and together, they form the entirety of the debt financing terms and conditions.

Common Financial Accommodations

There are many ways in which to structure a loan agreement. The following are several options generally available to debtors:

Direct Loan

A direct loan is a financing arrangement where funds are borrowed directly from a creditor without intermediaries, and the debtor pays the principal of the loan, plus interest, directly to the creditor. A direct loan can be provided in any currency. Still, it is important to note that in the event of default or breach of the loan agreement, the courts of Canada are limited to awarding judgements in Canadian currency.

Direct loans are typically offered as a demand loan, where the creditor can demand repayment at any time, or a term loan, where the loan is provided for a specified period of time, and the repayment obligations trigger in the event of a default or after the maturity date. In terms of repayment, the loan agreement can specify that payments must be made regularly and periodically and can be prepaid on certain terms and conditions.

Depending on the parties’ needs, a loan agreement can be evidenced by a promissory note, which is a debtor’s promise to repay funds to a creditor on certain terms. They can also be structured on a demand or term basis.

Letters of Credit

A letter of credit is issued by a creditor, typically a bank, guaranteeing that a seller will receive payment from a buyer upon meeting specified conditions. The purpose of a letter of credit is to secure payment obligations to the beneficiary of the transaction. These instruments are typically used in international transactions. The lending bank will typically have a reimbursement agreement with the debtor, who will sometimes provide security to the bank in case the beneficiary calls the letter of credit.

Bank Guarantees

The Bank Act allows chartered banks to guarantee the payment of funds. They work similarly to a letter of credit except that the beneficiary of the guarantee cannot demand payment unless the debtor has defaulted on their repayment obligations.

Enforcement in the Event of Default

If a debtor fails to repay the loan per the terms and conditions agreed to by the parties, the debtor may enforce the repayment. This can be done by the terms of the agreement or through various mechanisms afforded by law. The success of enforcing a debt depends on the creditor’s priority in repayment, which is determined by whether the debt was secured or unsecured and whether the secured creditors had registered and perfected the security. We have previously written about the priority of repayment between creditors.

Even so, creditors may obtain judgments to enforce repayment, which could involve writtenor asset seizure, and bankruptcy proceedings provide relief for debtors unable to meet obligations. However, creditors may receive only partial repayment.

To understand your options when trying to repay loan obligations, it is important to consult with an experienced corporate lawyer.

Contact the Business Lawyers at Bader Law for Advice on Corporate Financing

At Bader Law, our business lawyers help clients access new capital while maintaining control of their business and minimizing legal risk. We also work with clients to organize their business, manage information technology and licensing, and effectively address shareholder disputes that may arise. We work diligently to help our clients optimize their business by choosing the best structure and legal composition for their operation. Contact us online or at (289) 652-9092 to schedule a consultation with one of our talented corporate lawyers.