Congratulations – you agreed to terms with a bank on a new business loan. The banker drops off the agreement and tells you to sign here and initial there and the money is all yours, but do you completely understand what you are signing and how it may impact your business?
Unless you are a banker, attorney, or accountant that sees these documents regularly, you may have a few questions on your loan agreement. There are a lot of different parts of a business loan that can be misunderstood by the signer resulting in increased finance charges during default periods, or worse, force the bank to call your loan. Let’s discuss some of the more confusing and misunderstood areas of a business loan agreement to help you be better prepared the next time you find yourself with a pen in your hand signing that legal document.
5 Areas Often Misunderstood on a Business Loan Agreement
- Financial covenants: Let’s start with an obvious one. Most loan agreements require you to maintain certain financial ratio requirements during the term of your loan. These ratio requirements can vary depending on the type of industry you are in or the type of loan you are setting up. The ratio formulas themselves could vary depending on which bank writes it up and the bank’s identified risk factors. It is important to request clarification from the bankers on how the financial covenants will be calculated so that you can project and determine if those ratio requirements are sustainable in the future given your expected business model.
- Operating and Equity covenants: These covenants can restrict how you operate your business and how you allocate the accumulated equity you have built in your business without the bank’s approval. It is not uncommon to see restrictions on distributions out of the company even though your equity position may be strong. This is very important to consider if you are planning on using those distributions to make individual tax liability payments similar to most small and medium-sized business owners.
- Personal Guarantees: I am sure it is not a huge surprise to you that a bank would commonly require personal guarantees on most business loans, especially if you are a start-up business or if your company’s balance sheet is not as strong as the bank would like. What may be surprising to you is that you may be signing a loan agreement that has an UNLIMITED personal guarantee. If you are required to have a form of personal guarantee make sure to negotiate the limits of the guarantee and, if possible, set financial checkpoints within the agreement that can lower or even eliminate the personal guarantee overtime.
- Subordinated Debt: Within the same vein of why a bank would require you to personally guarantee a business loan, they may also require you to subordinate any owner or related party debt that may be on the balance sheet. This means that the bank would essentially treat the subordinated debt like equity, which strengthens the balance sheet position from their perspective, but also restricts you from paying down any of that subordinated debt until the bank loan has been satisfied. The impact of this should not be overlooked as this may put an indefinite hold on any personal loans you gave to the company in order to get the business up and running.
- Cross Collateralization: This is very important to consider for owners of multiple businesses as the bank may want to cross collateralize your business loan with the assets of some of the other businesses that you have ownership in. Not only could this put your other businesses at risk that you may not be 100% owner of, but depending on the situation and reporting requirements, this cross collateralization could trigger a Variable Interest Entity and force you to consolidate the activity of the cross collateralized business within your financial statements. This would cause increased accounting service fees on an annual basis.
These are just a few key areas to consider and make sure you fully understand before you sign on the bottom line of that loan agreement. Business loans can be very useful tools in growing and sustaining your business but if you are not fully educated, or fail to read the entire agreement, that same loan agreement could turn into a burden and ultimately hinder your company’s vision and future.
How DHJJ Can Help
DHJJ’s business advisors offer businesses and their owners several types of services, including helping to negotiate and understand the loan agreement. If you have any questions about loan agreements, please contact DHJJ, call DHJJ at 630-420-1360.
