In a commercial real estate transaction, term sheet and commitment letter interchangeably. However, both of them have material differences with different causes and effects.
When a commercial transaction takes place, sellers often rely on the ability of the buyer to cater for the financing required to close the deal. For this, the buyer generally issues a document in either a term sheet or a commitment letter, as per the scenario.
Most of the time, lenders are confused between the term sheet and the commitment letter since both serve the same purpose. However, there are notable differences that have different impacts on your transaction. But, before diving deep into the difference, let us first understand the term sheet and commitment letter individually.
What is a Term Sheet?
A term sheet is a formal nonbinding document showing the lender’s interest in arranging finances for the transaction. The paper is a summary of the essential points and terms under which a loan can be considered to lend. It is a document made in good faith and cannot be considered a commitment to lend money.
The terms mentioned in the term sheet are for negotiation purposes and are not intended to be taken as final. One can get a thorough idea of the transaction and the terms if they have received a term sheet beforehand. It is important to note that different types of transactions ask for different term sheets. Therefore all term sheets vary in content and format. However, a general format would ask you for the following details.
Format of a Term Sheet
The format and content of a term sheet differ with every transaction. A term sheet, however, asks you for some general details such as:
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Borrower’s Name
The term sheet requires the legal name of a borrower who must have a physical existence. Sometimes, people form a single-purpose identity for a particular deal. Therefore the potential borrower must have a legal entity of his own.
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Amount of Loan
The term sheet must mention the amount of loan that the borrower is seeking to pursue—however, the amount to be mentioned changes after the appraisal from the third-party valuation. So, even if you have defined the amount to lend, you can still expect it to change, as no details are final in the term sheet.
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Purpose of Loan
The term sheet takes into account the purpose of lending the said amount and where the required funds will be utilised. The reason mentioned should also have proof attached so one can make a reliable decision.
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Rate of interest
The term sheet must define the rate of interest as well. The rate of interest helps to know an estimated rate at which the lender may consider extending credit. However, the interest rate may also change after the third party’s influence.
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Maturity of Loan
The term sheet also demands mentioning the period for the loan’s maturity. The maturity period indicates the potential period that the lender might consider. For instance, the term sheet can state that the loan will have an estimated term of 3 years.
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Monthly Payment
If the term sheet decides on the monthly payment of interest, then an estimated calculation of the monthly payments must be presented in the term sheet.
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Collateral Security
If the term sheet states a provision for collateral security on a loan, then it must mention a description of the collateral.
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Guarantee
The term sheet also requires you to provide a personal guarantee to anyone sponsoring the transaction. The guarantor can be anyone in relation to the borrower who can witness and take the guarantee for the lending process.
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Performance Covenants
A covenant is a promise that the borrower makes to the lender about the estimated financial liquidity. The term sheet requires the details for the financial covenants where the borrower is required to maintain a minimum liquidity amount during the time period of the loan. Such liquidity has to be maintained at all times during the period.
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Items needed for closing
For closing the term sheet for a loan, you may need some financial instruments like tax returns, environmental review reports, appraisals, financial statements, project plans, and purpose statements. Such information must be treated as confidential by both parties.
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Closing date
The term sheet can reach a potential closing date once all the terms and conditions of the term sheet are met. Both parties can fix a date mutually to close the transaction.
The term is issued in the early stage when it comes to a loan transaction. Such a document is used by the borrower to disclose the same to their sellers and investors that will be receiving the financing from a lender soon. The document varies in application and terms when compared with a commitment letter. Let us understand what a commitment letter is in detail.
What is a Commitment Letter?
The main difference between a term sheet and a commitment letter is that the latter document is a commitment to lend. A commitment letter is a binding legal agreement promising a term loan or credit facility. They are generally issued when the loan cycle is about to end. You can issue a commitment letter only after the successful completion of your loan cycle.
Simply put, your transaction must be through a complete underwriting and approval cycle. Just like a term sheet, the content and format of a term sheet vary with different scenarios. But, to come under a commitment letter, the document must have the following:
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Be in writing
The commitment letter must be in writing so that all the terms and conditions are already mentioned in the loan agreement. Agreements in writing also prevent the challenges in oral agreements.
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Involve basic terms
Just like the term sheet, the commitment letter must also mention basic information like the amount of loan, repayment structure, rate of interest, penalties, voting rights, warranties, and other terms.
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Must have a legal disclaimer
The commitment letter must have a legal disclaimer for both parties, the borrower and the lender, to protect them from any possible disagreements.
The commitment letter is finally signed by both parties, which means that they are legally liable for any fault n the agreements. The borrower can also use the commitment letter in front of the sellers and the investors to give the third party the confidence to close the deal.
Final Words
It was all you needed to know about a term sheet and commitment letter. The key difference between the term sheet and the commitment letter is that the term sheet is a non-legal document that is presented at the beginning of the transaction. In contrast, a commitment letter is presented at the end of the transaction with the objective of providing a commitment for closing. A commitment letter is a legal document, unlike a term sheet, and works as a final document in the transaction. If you want to know more about the term sheets and commitment letter, you can get in touch with our legal experts at Vakilsearch.
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