In the era of clicking "I agree" on just about every terms of service agreement, it's important for you to read your loan documents. Unlike technology privacy policies or other service contracts, your loan document is packed with details and requirements for your business. Ignoring what's expected of you means the bank will recall the loan, leaving you without the funds you needed in the first place.
It may be a common belief that banks hide nefarious terms throughout loan agreements to play "gotcha" with business owners, but understanding a loan agreement comes down to simple awareness. Before you sign, ask your lender questions. If you're struggling to follow the more technical aspects, review it briefly with an attorney or an experienced business owner.
"Borrowing money and lending money is based on trust," said Rene Kakebeen, a lending specialist who provides small business loans. "Borrowers need to read [the agreements] and understand what they're saying. And if they don't understand, they should either ask the lender or go to their attorney."
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Loan agreements are broken down into several different sections. The most important sections for small business owners are the positive covenants, negative covenants and reporting requirements, according to Kakebeen. These three sections outline everything you can and can't do, and they provide a framework for annual or quarterly reporting habits. These sections, and the section detailing defaults, are the areas you should scrutinize before you sign.
Taking out a loan means more than just meeting your payments each month.
"They [borrowers] think in terms of repaying my debt," said Stuart Wolfe, an attorney at Wolfe & Wyman who handles finance loan agreements. "The terms seep into much larger issues in your company's affairs."
Loan terms can apply to aspects like a change in ownership (even if the business is being passed on to a family member), a change in business insurance or making the lender your primary bank for the duration of the loan. Some terms even extend beyond the primary company to its subsidiaries, according to Wolfe.
Getting a small business loan means ironing out exactly what it is you need to do so you stay compliant with your bank. This allows you to get the loan that fits your business's needs best, and it provides you with the opportunity to build a relationship with your lender.
The reporting requirements section outlines the financial reporting required of you. Kakebeen said that the fine print will outline when and how to submit documentation. It's important to pay attention to the quality of this documentation as well. He said that there's a big difference between a company-prepared financial statement and a fully audited financial statement. So much so that it can be a $10,000 swing in some cases.
If you fail to meet certain reporting requirements, the bank can call the loan, which means you'll enter the default process. Kakebeen said the purpose of these requirements is to provide a look into your cash flow and operations, which sheds light on debt-service coverage ratios and other important financial indicators. It allows the bank to keep an eye on your business as it grows and changes.
Kakebeen said don't assume that because you already have the money and the loan has been approved that you don't have to provide financial documentation when asked. In some instances, your lending officer may be able to ask for additional information.
"Many lenders have lots of reporting requirements and borrowers tend not to read those," he said. "They're more interested in getting the money than worrying about financial statements and reporting requirements."
Debt-service coverage ratios
One of the things reporting does is that it informs the bank on whether you're maintaining the correct debt-service coverage ratios (DSCR). These ratios are outlined in the loan agreement, likely in the positive covenants section, according to Wolfe.
Debt-service coverage ratios define a company's ability to meet its current debt obligations based on its cash flow. A 1.25 ratio, for example, means you'll have to cover 100 percent of your operating debt and have 25 percent of your funds left over to continue your businesses operations.
It's important to be aware of what the bank requires and how you'll meet those standards. Sure, decreased sales are an obvious issue that affects your DSCR, but it's important to be aware of others. If you're running a seasonal or cyclical business, for example, you'll want to talk with your lender about setting up ratios that make sense for your cash flow throughout the year.
More importantly, Kakebeen said that taxes and tax returns can have an impact on cash flow to the point where it could push your DSCR below the bank's limit. This is another indirect way for you to violate the loan agreement.
"You need to talk to your CPA and say these are my requirements, I need to be at these ratios so I don't end up in default," he said.
Prepayment penalties are fees the bank charge you should you pay off your loan in one lump sum. Prepayment penalties are usually outlined in the positive or negative covenants section, or they have their own section entirely.
These fees may feel like a punishment despite you honoring your pledge to repay the loan, but they can often protect banks. Wolfe said it's important for business owners to consider that if the loan is the primary line of credit or type of financing, it's likely a big sum for the bank.
The bank counts on the loan to be fully amortized (which means both principal and interest are paid off) over the entire term – let's say 10 years. Wolfe said if the bank is expecting 10 years of principal and interest payments, and you pay off your loan in four years, it misses six years of extended profit.
"Part of the value of the loan is having a long-term extension of credit – from their point of view – at a certain interest rate," he said. "They're going to sell that loan, they're going to use that loan as an asset performing at a certain interest rate. They've lost the rights if it's paid off early."
The nature of prepayment penalties may not be inherently bad, but if you don't address or understand their structure, they can come back to bite you. Alex Espinosa is an SBA lending consultant and founder of Bold Lender. He said it's important for business owners to be aware of yield maintenance prepayment fees. These fees can be used to block business owners from refinancing at a lower rate.
"The most common reason for loan prepayment is a drop in interest rates, which provides an opportunity for a borrower to refinance," he said in an email. "Yield maintenance allows the bank to get their original yield without any loss in a falling interest rate environment."
While this is a common banking practice in some regard, Espinosa said that sometimes it's used with small business lenders who aren't aware of how high these payments can be. Again, while this may not be an ideal situation, if you're aware of what's in your contract, you can avoid it.
Wolfe said it's important for business owners to consider how banks need to protect their loans. He also said banks are usually willing to work with business owners on a few of these issues.
"Their goal is not to have a 'gotcha' moment and call default on the loan," he said. "Their goal is to underwrite their risk of making this loan on whatever terms they've agreed with."
Negotiate your loan, know the terms
Wolfe stressed that a lot of a small business's loan agreement can be negotiated with the lender. You may not need a lawyer to do the negotiating, but it can help to have an attorney review your agreement before you sign.
"Even when you're dealing with a large bank against a small business owner, much of it is negotiable," Wolfe said. "They do want the business."
By scrutinizing your loan agreement and picking out what you want to adjust, you can protect your business and ensure you stay compliant with your lender.
"Whenever you get into a lending or borrowing situation, go into it with your eyes open," Kakebeen said. "Don't assume that everything is in your favor or that because you're going to get the money nothing else matters. It does matter."