You've survived the financial inquisition, the scrutinizing of your character and competence, and you've managed to convince the bank that you're a safe enough bet to merit a business loan.
So, what happens next?
Well, get ready for a case of eye strain and writer's cramp. Your reading glasses and your signing hand are going to get a workout. So is your noggin. First-time business borrowers often feel overwhelmed by the volume and complexity of the documents they'll have to understand and sign once their loan application has been approved.
Commitment letters, promissory notes, credit agreements, mortgages, assignments and guarantees -- all of these and more can be part of even a relatively modest commercial loan.
We'll touch on a few high points, but there is much more to know. This brief primer will help prepare you to ask better questions of your banker, your attorney and your accountant when finalizing the loan.
Different lenders may do things somewhat differently, but here's basically how things start. The banker provides a commitment letter telling you how much it will lend and what it requires as collateral for the loan, spelling out any other terms, and setting the amount of commitment fee to be paid.
Lenders charge commitment fees for the cost of approving and processing the loan. Commitment fees on commercial loans typically range from 0.25 to 1% of the loan amount. If you borrow $250,000, the commitment fee will be between $625 and $2,500.
Some banks require that it be paid in a single lump sum when you sign the loan agreement. Others will wait until the actual funding of the loan.
Also called a loan agreement, this document describes the type of credit arrangement involved (a term loan or a revolving line of credit, for instance), the amount of funds borrowed, the interest rate and maturity date of the loan, and whether the loan may be prepaid.
In addition, it usually describes the procedures you'll have to follow to receive funds. If the lender is charging a commitment fee (also referred to as a “facility fee”), the amount of the fee and terms of payment will usually be included in this portion of the loan agreement.
As the name implies, this is a written promise that you'll repay the lender an agreed upon sum of money. It contains many of the terms and conditions already set out in the credit agreement. So why do you need it? Because while the credit agreement is the contract by which you enter a creditor-debtor relationship with the lender, the actual loan is represented by the promissory note.
Representations are statements of fact made by you. Basically, they're assurances that the assumptions the lender has made about your creditworthiness, business structure, financial condition and state of your assets are true and accurate. Warranties are contractual duties created by the loan agreement itself.
It's important to note that representations and warranties are specific to the date they were made. They're a snapshot in time. They do not (or should not) require you to state what will be true in the future. You can't be expected to know that. Besides, lenders will use covenants to mitigate future uncertainty.
Some common representations and warranties include statements that:
These are promises you make to take (or not to take) certain actions, and they govern the ongoing relationship between you and the lender for the life of the loan.
Affirmative covenants are lender-imposed guidelines you must follow in the operation of your business. Negative covenants prevent you from changing the structure or nature of your business without the lender's consent. Financial covenants establish set guidelines for operation of your business and financial condition.
Some common types of affirmative covenants require you to:
Some common negative covenants prohibit you from:
Some common financial covenants:
Failure to comply with a covenant triggers a default and the lender's right to terminate the loan, accelerate repayment (declare the loan immediately due and payable) and foreclose on the assets that serve as collateral.
Commercial loans are always secured by the borrower’s assets and, in some cases, additional collateral. Assets include real property, personal property and equipment, cash and cash equivalents, assignments of income streams (rent, insurance proceeds, and investment income) and deposit accounts.
You can expect to sign a security agreement pledging all business assets to the lender and granting the right to foreclose upon the assets in the event of a default. A guaranty is a promise by one person to repay the debt owed by the borrower to the lender in the event the borrower does not pay. A corporate guaranty is when a corporation or limited liability company promises to pay the borrower’s obligations to the lender in the event the borrower defaults. A personal guaranty is when an individual person guaranties repayment of the borrower’s debt owed to the lender.
These are the legal rights of a lender in the event you fail to make payment on the loan, fail to comply with any covenants, or are otherwise in breach of the terms of the loan agreement. Failure to comply with the terms of the loan agreement is referred to in loan agreements as an “event of default.” A significant portion of all commercial loan agreements is dedicated to the consequences to the borrower and rights of the lender in default.
Consultants at our Small Business Assistance Office can help you understand more about the basics of loan documentation. And our network of Small Business Development Centers has experts located in nine main regional offices and several satellite centers statewide.
For an in-depth examination, see our publication Loan Documentation: An Introduction for Small Businesses. Our Guide to Starting a Business in Minnesota covers this and other important issues.
Refer to this information, Financing Your Business, from the U.S. Small Business Administration.
