13 Sep How to Review Your Business Loan Documents

Business Loans – What Should You Know?

Ralph and Antonio are two business partners who have known each other since their college days. They built a successful manufacturing company, but growth had begun to plateau.  They wanted to expand and figured they could use a business loan to finance their new facilities.

They went through underwriting with the bank and they were excited about the infusion of capital they were going to be getting.  In their excitement, they breezed through the loan documents, barely reviewing them other than to confirm the loan amount they would be receiving. 

Ralph trusted Antonio to handle the paperwork, and Antonio trusted their bank to have their best interests in mind. Neither Ralph nor Antonio took the time to truly understand what they were agreeing to.

Changing Business Climate

A few years down the line, business slowed. Cash flow got tight. That’s when Ralph and Antonio discovered some surprises in their loan documents.  Surprisingly to them, their personal assets were tied to the company’s debts and allowed the lender to demand immediate repayment under certain conditions that Ralph and Antonio hadn’t anticipated. Worse yet, they were locked into terms that made refinancing almost impossible. The revelations strained their relationship, threatened their business, and ultimately put their families’ finances at risk.  Ralph and Antonio felt blindsided by the terms in their loan documents, but they admitted to themselves they needed to be more careful about understanding what they were getting into when they signed the documents years ago.  Going forward with that understanding would have helped them prepare for and avoid the problems they were having now with their lender.

Your Framework – Know What to Expect

Unfortunately, Ralph and Antonio’s story is not unique. Most business owners have a lot on their plate and assume the loan process is just a formality. But the truth is, misunderstanding the loan documents you sign can cripple your business. Before you put pen to paper, you need to know exactly what you’re getting into.

The exact details of business loan terms vary from loan to loan, but you can still be prepared by knowing the general structure of common loan documents.  Understanding the typical core loan documents required in almost every business loan will help you zero in on what’s most important and help you stay on the right side of your lender. 

Here’s a breakdown of the key loan documents you’ll encounter and what to watch out for in each.

1. The Promissory Note

The promissory note outlines the terms of the loan. It’s your formal promise to repay the lender according to a specified schedule. At its core, it’s a contract between you and the lender (like a bank or lending institution).

Pay special attention to:

* Interest rate: Is it fixed or variable? A variable rate could mean higher payments down the road if rates increase.

* Repayment terms: Pay attention to how often payments are due and what happens if you miss one. Does the lender offer a grace period, or will penalties kick in immediately?

* Prepayment penalties: Some loans penalize you for paying off the loan early, which could hinder your ability to refinance or sell the business in the future.

2. The Security Agreement

Most lenders will require collateral, and that’s where the security agreement comes into play. This document grants the lender a security interest in certain assets—whether it’s equipment, inventory, or accounts receivable—that they can seize if you default on the loan.

Pay special attention to:

* Scope of collateral: Be clear on what assets are tied to the loan. Are you only offering business assets as collateral, or does the lender have the right to go after personal assets too?

* Default conditions: Understand exactly what constitutes a “default.” Is it just a failure to make payments, or are there other triggers like missing certain financial benchmarks?

3. Personal Guarantee

If your company is a small, closely-held business, there’s a good chance the lender will ask you—and possibly your partners—to sign a personal guarantee. This essentially makes you personally responsible for repaying the loan if the business can’t.

Pay special attention to:

* Extent of liability: Are you liable for 100% of the loan, or only up to a certain amount? If you have partners, are all of you jointly liable, or is the liability split among you?

* Impact on personal finances: Signing a personal guarantee can put your home, retirement savings, and other personal assets at risk. Consider how much exposure you’re comfortable with.

4. Covenants

Loan agreements often come with covenants—promises that your business must maintain certain financial conditions, like minimum revenue levels or debt-to-equity ratios. These covenants are a way for the lender to monitor your company’s financial health throughout the loan term.

Pay special attention to:

* Types of covenants: There are two main types—positive and negative. Positive covenants require you to take certain actions, like maintaining insurance. Negative covenants restrict your actions, like preventing you from taking on more debt without the lender’s approval.

* Consequences of breaching covenants: Failing to meet these covenants could trigger a default, even if you’re making all your payments on time. Understand the consequences and negotiate more flexible terms if needed.

5. The Loan Agreement

The loan agreement is the document that ties everything together. It outlines the broader terms and conditions of the loan and may include additional clauses that govern how the lender can act if things go wrong.

Pay special attention to:

* Acceleration clause: This allows the lender to demand full repayment of the loan immediately if you violate certain terms of the agreement. Be aware of what actions could trigger this clause.

* Cross-default provision: This clause can cause a default on one loan to trigger defaults on others, which could create a domino effect if you’re juggling multiple lines of credit.

* Change of ownership clause: If you plan to sell the business or transfer ownership, be sure the loan doesn’t automatically come due under a change of ownership clause.

6. UCC-1 Financing Statement

This document is filed with the state to give public notice that the lender has an interest in the assets listed in the security agreement. It’s a simple but important document that establishes the lender’s right to seize collateral if you default.

Pay special attention to:

* Accuracy of information: Ensure that the description of the collateral is accurate. Mistakes or omissions here could create legal headaches down the road if the lender tries to claim assets you didn’t intend to pledge.

Go Into Your Loan With Eyes Wide Open

To get your loan, you will need to sign loan documents.  Loan documents are contracts and, just like all contracts, the fine print matters.  As the leader of your business, it’s on you to know what you’re agreeing to—not just for your sake, but for the sake of your company and your family.

Need help deciphering your loan documents?   Don’t take chances with your financial future.

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