Loan documents can be difficult to read (literally, small font, single spaced, and long) and hard to understand (full of legalese and terms you might not understand).
However, financing documents are a part of almost every business and understanding the rights and responsibilities of the business under those documents is incredibly important. Here are some helpful tips to protecting your business when financing a deal.
- Understand How Much the Financing is Ultimately Going to Cost: Unlike consumer loans, the loan documents for an extension of credit that is primarily for a business, commercial or agricultural purpose are not required to contain the normal Truth In Lending Act and Real Estate Settlement Procedures Act disclosures that lay out: the annual percentage rate on the loan; the finance charge; the amount financed; and, most importantly, the total payments the borrower will make. Accordingly, you will need to do the math and find out exactly how much the credit being extended to your business is going to cost over the life of the loan.
- Understand the Events of Default: Most commercial loan documents contain an extensive “Events of Default” section that lays out a whole host of circumstances under which the lender can call the loan in default even if your business has never missed a single loan repayment. Common events of default include: the death of one of the personal guarantors of the business loan; the bankruptcy or insolvency of the borrower; a material adverse change in the borrower’s business; and the breach of financial or other loan covenants.
- Understand the Financial and Other Covenants in the Loan Documents: A covenant is a promise contained in the loan document that certain activities will or will not be carried out by the borrower. As a borrower you will be required to provide information to the lender that you are in compliance with the loan covenants.
Financial covenants are the most common and often address the financial ratios that a borrower must maintain, such as a maximum debt-to-asset ratio or other such ratios. Lenders put such covenants in place to protect themselves from borrowers defaulting on their obligations due to financial actions detrimental to themselves or the business.
Other common covenants are so called “affirmative” or “positive” covenants that require the borrower to perform specific actions. Examples of affirmative covenants include maintaining adequate levels of insurance and providing the lender with taxes and/or audited financial statements.
A violation of any of these covenants is almost always also an event of default. Certain loan documents may provide a borrower with a grace period to remedy the violation. If not corrected, however, lenders are entitled to call a default on the loan and demand immediate repayment of principal and any accrued interest.
- Understand Cross-Default: A cross-default clause in the loan documents states that the default as to one loan with the lender is a default as to all. This can be particularly, tricky when the business loan is personally guaranteed by the owner of the business. In effect, if the business defaults then the guarantor is also deemed to be in default of his/her personal loans with the lender and vice-versa.
As a practical tip, if you have any questions concerning your responsibilities under the financing documents you are about to sign ask for the lender or an independent attorney to go over the documents with you and to explain those responsibilities in detail.
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