Anatomy of a Loan Document
Congratulations! Now that you've worked out a good business plan, overcome the challenge of putting yourself under the hot spotlights and filled out the small boxes on the bank-loan application, your small-business loan has been approved. The bank's loan officer calls you with the good news and arranges a meeting to "close" the loan. If you're like most entrepreneurs, you're ecstatic, and you happily agree to sign the papers to get the check. But what does all the legal jargon in that stack of papers really mean?
"A close look at those documents now could save you a lot of headaches later," cautions Mike Wellman, a CPA in Longview, Texas. "You're in a good bargaining position from the time of your first meeting until the time you submit your application. Your negotiating power dissipates substantially once the loan has been approved, and vanishes completely after you've signed the documents."
When Janet Long, founder of Integrity Search Inc., a Springfield, Pennsylvania, executive-search company, needed capital to expand her rapidly growing business, she put off meeting with banks, fearing volumes of paperwork, long delays and rigid guidelines. "My CPA and I put together a sound expansion proposal, and I was pleasantly surprised at how easy the process went," she says. "At first, the loan documents were a bit overwhelming, but, with my lawyer's help, I gained a full understanding of what the legalese meant."
In fact, many bankers encourage loan applicants to understand the loan documents before they even complete a formal application for a loan. "It's true that most small-business owners sign the documents with only a cursory review," says Rhonda Wills, senior vice president at Bank of Astoria in Astoria, Oregon, and chairperson of the American Banker's Association Small Business Committee. "Generally, it's a good idea to get the loan documents ahead of time so you have a chance to review them for a couple of days before you sign them. Most bankers won't have a problem sending advance copies of the documents, but they will generally only do so if they're specifically asked. The documents can be somewhat complex, so most bankers are willing to help you understand what the fine print means."
Although it varies slightly from bank to bank, a small-business loan package usually comprises several documents, including a loan agreement, a promissory note and some form of guarantee and surety agreement.
The loan agreement will contain what are commonly known as "representations and warranties" of the borrower. These provisions serve as your promise to the bank that you've complied with certain conditions. The bank will ask you to affirm, usually by affadavit, that you're authorized to bind your business to the loan terms (known as "binding effect" and "due authorization"). You may also be asked to deliver your business's financial reports for review, either annually or quarterly, for a term specified in the loan agreement.
Finally, most banks require you to verify that all the information on your loan application is still true before they disburse the loan. If your business has suffered a significant financial downturn that may affect your borrowing ability, avoid the temptation to keep it quiet.
"It's generally in the bank's interest to work out a solution," Wills says. "In the majority of cases, we'll still offer the loan."
If you believe your business can't keep each of the outlined promises, contact your loan officer for clarification or modification of the language. Remember that all the loan documents are tied together, in that breaching a single promise is enough for the bank to declare your loan in default.
The promissory note details the principal and interest amounts owed and when payments are due, and it outlines the events that would allow the bank to declare your loan in default. While failing to make timely payments is an obvious cause for default, there are other circumstances that allow the bank to declare a default on your loan. Knowing (and perhaps negotiating) the provisions of default ahead of time will help protect your credit record and personal assets.
Look for "cure" language in the default section. A cure provision allows you a certain time period, usually 10 days, to remedy the default after you've been notified by the bank. You may need to ask to have such a provision included; if your loan officer is leery of cure provisions, explain that your primary concern is defaulting accidentally. If a payment gets lost in the mail, for example, and your bank notifies you that you're in default because of the missed payment, a cure provision allows you time to issue a new check to the bank.
Once you understand what constitutes a default, you need to know what the bank can and can't do after declaring a default. It's commonly spelled out in the "bank's rights and remedies" section of the promissory note. Loosely, a "remedy" is defined as the actions the bank may take if you default on your loan. Look for the following:
* Security interest. The promissory note usually contains a provision, commonly known as security interest, that protects the bank's interest in your collateral. The language of the security interest will generally be focused around your particular type of business and the specific collateral covered. For example, if you own a business that requires you to purchase equipment with your loan, the bank will take a security interest in that equipment. If you stop making payments--or default in any way--the bank has the right to seize the equipment and sell it to satisfy your payment obligations.
Most loan documents also include a bank's security interest in your inventory, accounts receivable and even future contract rights. Be on the lookout for language that grants the bank a security interest in "hereafter acquired" equipment or inventory. Banks often want you to give them a security interest in any equipment or inventory you buy, even after the proceeds of the loan are distributed. This could affect your business's ability to finance equipment or inventory in the future, so urge your loan officer to restrict the bank's security interest to property you already own.
The bank will "perfect" its security interest by asking you to sign a standardized form known as a UCC-1. This form begins the process of recording the bank's security interest on the public record on both the local and state levels.
- Acceleration. This remedy allows the bank to declare the entire amount of the loan due and payable at once. Once your payment terms have been accelerated, the bank is in the position to take all the collateral you've pledged to secure the loan.
- Confession of judgment. Known as the "nuclear bomb" of remedies, some states have outlawed such provisions as too anti-consumer, but most banks still insist on including them. In sum, a confession of judgment clause allows the bank to declare a default, accelerate the full amount, enter a judgment in your local court without your being present--or even notified--and begin to collect the unpaid balance, all in the same day. It's an onerous provision, but most banks won't allow their loan officers to exclude it. "Confession of judgment is the absolute last resort," Wills says. "Most banks will only confess if they think the loan is in serious jeopardy."
Guarantee and Surety Agreement
Because most start-up businesses have insufficient assets or operating history for the bank to risk a loan, lenders often require the principals of the business to guarantee the loan with personal assets.
In essence, a personal guarantee is your promise to the bank that, if your business fails and can't pay the money back, you'll pay back the loan with your personal holdings. The bank may ask the principals to secure the loan with the equity in their homes. Don't think you can simply walk away from a defaulted loan just as you can walk away from the business. Although banks are generally reluctant to foreclose on a personal residence to satisfy the loan obligations of a small business, be aware that the bank can and will force the sale of your house if it can't recover the loan by any other method.
Many small-business advisors recommend negotiating a restricted number of years for the guarantee if the small business has been punctual in its payment schedule.
If you're not satisfied with a bank's willingness to negotiate terms, take your business to a bank that will be more flexible. If you've been approved for a loan with one bank, chances are you can take that same loan package to a competing bank and negotiate better terms. A little footwork, close attention to the fine print and a working knowledge of the legal issues in loan documents will help to make your business stronger and build a positive working relationship with your bank.