Taking out a business loan can be scary. No matter how eager you might be to sign on the dotted line and receive a cash infusion from the bank, either you or your legal counsel (if you have one) should first carefully review the terms of the loan agreement, which can have significant consequences. I’ve often explained to clients that there’s usually only one section of a loan agreement that’s in favor of the borrower — the one stating the dollar amount of your loan (the loan amount).
It’s a good rule of thumb to assume that every remaining word of the loan agreement (sometimes called a credit agreement) is specifically designed to maximize the bank’s chances of getting its money back. This is why lenders invariably insist on preparing the initial draft of the loan document, which likely incorporates boilerplate language that is highly favorable to them. It’s up to you and your legal counsel to review the document and negotiate the fairest deal with the bank as possible. Here are the issues that you should pay the closest attention to.
Most credit agreements will have defined terms. These are capitalized words, usually set off in quotation marks (“_____”), that are intended to mean the same thing every time they appear in the document. Most contracts use defined terms to improve the document’s efficiency, clarity, and consistency.
Usually, these defined terms are listed in a separate section, either at the very beginning or the end of the loan agreement. In any case, you should read the definitions for all capitalized terms before reading one word of loan agreement. This is so that you can have a full understanding of what these terms mean as you read through and interpret the provisions of agreement. Furthermore, it’s quite possible that you’ll take issue with how the bank defines certain terms. For example, the meanings of “Affiliate” or “Permitted Liens,” or financial terms like “EBITDA” or “Net Revenues,” could have significant effects on your various obligations under the agreement.
Interest and Repayment Terms
With the exception of the loan amount, borrowers are usually most concerned with the interest rate and repayment terms. It will be up to you to negotiate an acceptable interest rate and repayment schedule, based on your financial capability, revenue projections, and relative bargaining power.
You should note that each state has its own usury laws that prohibit banks from charging excessive interest rates. See Nolo’s article The Lowdown on Business Loans for additional discussion on this topic. Also, you should be conscientious about negotiating a repayment schedule that is not only feasible (with a little bit of wiggle room), but also allows the company to pay down its debt as systematically as possible. Most importantly, your repayment schedule should be flexible enough that you can avoid defaulting under the loan agreement, which could have disastrous effects (as discussed below).
Your credit agreement will probably include an entire section devoted to events of default. You should review this section extremely carefully — multiple times if you have to. This is because breaches of a loan agreement can have many negative effects on you and your business. One thing to keep in mind when reviewing the default provisions is to be realistic about whether or not you and your company will be able to satisfy every requirement (called covenants). For example, your credit agreement could require your company to maintain certain balance sheet ratios, deliver periodic financial reports to the lender, or get consent from the bank prior to taking certain actions (for example, selling assets, creating a subsidiary, settling a litigation claim, or hiring a new senior officer).
To the extent possible, you should heavily negotiate the substance of each covenant in order to maximize your company’s ability to comply. You can also soften default provisions and covenants by using any of the following strategies:
- including generous cure periods for breaches,
- adding “knowledge” and “materiality” qualifiers,
- incorporating minimum or maximum dollar limits (as applicable), and
- insisting that any penalties or other ramifications must immediately cease once the underlying default has been cured or waived.
In short, you want to take every opportunity to either delete or adjust any language in the default provisions, and the rest of the loan agreement, that could cause your company to inadvertently breach the contract and give the bank the right to assert any of its draconian remedies.
Understand the Consequences of Defaults
It is often said that defaulting under a loan agreement can create a “parade of horribles.” At the very least, any default increases the company’s administrative burden of comprehending, managing, and remedying the situation (including monitoring cure periods). Not only should you protect yourself from unintended breaches, but you should also fully understand the ramifications. Credit agreements typically state that in the event of a default, the bank can basically do whatever it wants, including taking ownership of your stock, entering your premises, making managerial decisions, selling your assets, and so forth. While it might be quite difficult to convince the lender to temper its remedies in any way, it’s certainly worth your while to give it your best effort.
Pledging Your Collateral
A lender’s confidence in offering your company a loan will be based on its analysis of your ability to repay it. Banks also protect themselves by demanding pledges of as much security (collateral) as possible, which they can then lease, manage, or liquidate in the event of a foreclosure. Collateral can take the form of any cash or assets that the company currently owns or might be entitled to in the future. Lenders often require companies to sign separate security agreements (including intellectual property assignments) that grant liens on its assets, including tangible and intangible property. Note that it’s also customary for banks to require your company to maintain specific insurance coverages. Finally, the credit agreement might compel you to have your landlord sign a waiver and consent agreement that permits the lender to enter your business premises and remove all property in the event of default. Because landlords frequently contest these agreements (for various reasons), this can add complexity to the loan process.
The bank can also request stock pledges from you and any other owners of the company. This means that in the event of default, the lender would be permitted to foreclose on your stock and seize ownership of the company, which clearly is a result that you would want to avoid at all costs. Also note that you should be wary of any provisions in the loan agreement (or any ancillary documents) that grant the lender an option to convert the company’s outstanding debt into stock; sometimes lenders want the right to exercise this option at any time, whether or not a default is in effect, which is even more problematic. Always remember that — as a cardinal rule — the last thing you ever want to relinquish is ownership control of your company.
Cosigners, Guarantors, and Personal Guarantees
Often lenders will require that the loan agreement be guaranteed by a parent company, subsidiary, or some other affiliate. In some cases, the bank could even ask you, as the owner, to sign a personal guarantee. As you might guess, there are numerous risks involved in doing so, including the loss of limited liability protections. See the Nolo article mentioned above for further insight.
Review Ancillary Document Terms for Consistency
Depending on the lender, it will likely require the company to sign documents other than the loan agreement itself (ancillary documents), including a promissory note and the security agreements, stock pledges, and landlord waivers mentioned above. Note that these documents will likely have their own provisions with respect to covenants, defaults, and other critical issues. You should also carefully review these ancillary documents in order to ensure that they are 100% consistent with the terms of the main loan agreement. In other words, you don’t want to be in a situation where you’ve negotiated a softening of certain default provisions in the principal document, but then you inadvertently violate more onerous default provisions in an ancillary document. One way to address this issue is to have any references to defaults in the ancillary documents strictly defer to the default provisions under the loan agreement, with no additional detail.