By Nancy A. Park
Business owners are often so worried about money and obtaining enough of it to capitalize their businesses that by the time the loan documents arrive, they are ready to sign on the dotted line and be done with it. However, this is a crucial time to step back and make sure that what you are signing up for is what you bargained for. Otherwise, you might find yourself and your business hampered by so many bank consent requirements that you can’t operate your
business effectively. Or worse, you default on your loan without realizing it and there is no way to pay it when the bank calls it due early.
Loan documents are often a tall stack of long, boring and finely printed contracts with lots of boilerplate language. The dirty little secret of loan documents is that the “gotchas” are hidden in this so-called boilerplate. Have your summary of terms (or letter of interest) from the bank right next to you as you read the loan documents from beginning to end.
Then focus on the following five areas to prevent the mistakes borrowers most often make.
1. Check the facts: Is the borrower’s name and entity correct? At a minimum, check loan term (maturity), interest rate, names, payment amount, amortization, addresses and collateral description. Make sure references to interest rate, loan term, payments and other key loan terms match up with your summary of terms. Are the right properties or fixtures being included as collateral? Pay particular attention to “financial covenants,” such as maintaining a certain net worth or cash balances or ratios, and the timing of financial reporting. Be sure that the loan documents give your business time to cure problems if these requirements are not met during the loan term.
2. Review the possible defaults: There might be several places in the documents that list loan defaults, such as failure to pay by a certain time or failure to perform other loan terms. If any of the defaults seem like a real risk (now or during the loan term), then you should discuss this with your banker so you
are not backed into a corner from day one. Ask for a cure period for every default, and avoid having the loan declared due as the first remedy by the bank. Some common events leading to default are failure to pay, death of a key person in the business, or sale of the business or its major assets.
3. Representations and Warranties: Borrowers are usually asked to make numerous statements of facts or beliefs in the loan documents, called representations and warranties. Some of these can be very broad or include facts that the borrower may not actually know. It is important that you read carefully and feel comfortable that each statement is correct and within your knowledge. It is OK in many instances to limit these statements to the best of the borrower’s (your) knowledge.
4. Loan or Credit Agreements: One important loan document is a loan or credit agreement that contains the loan terms specific to your operations. Ensure the bank has not tied your hands with regard to your main line of business, such as prohibiting certain contracts or transactions. Often banks require their consent before allowing certain actions to occur. Be sure that key business activities are not restricted, or you have authority to act up to a certain limit before the consent of the bank is required. Ideally, the bank will have no say in key business decisions, but if it does, require the bank to act within certain time frame so it will not handicap your business activities.
5. Check for Other Terms: If something seems odd or overly restrictive, now is the time to get these things explained in plain language by your banker. Don’t be put off with phrases like “That’s just what the loan docs say, it never really happens that way.” Loan documents are enforced by the actual language that is included. It is extremely important that you understand everything and correct any inaccuracies. If the banker is not able to explain certain issues or change loan terms, then you will need to weigh the risk of this issue occurring against your need for the loan.
You may think that the loan docs are just a necessary evil that should be accepted the way they are to reach the end goal of cash. However, there is no substitute for actually reading all of your loan documents and understanding the actual terms. Even better, allow a lawyer knowledgeable with the customary compromises agreed to by banks and borrowers to give your loan documents a careful legal review before signing on the dotted line.
Nancy A. Park is of counsel at Best Best & Krieger LLP in the Sacramento office where she works with clients in both the private and public sector, focusing on real estate transactions, finance and business contracts. Ms. Park represents private and public real estate entities, lenders and borrowers, landlords and tenants, and large and small businesses. She can be reached at email@example.com or 916-551-2849.Read More