Commercial Loan Documents: What Exactly Are You Signing?
Securing a commercial loan is a significant step for any business owner, whether you need capital to run your operations, purchasing new equipment, or investing in commercial real estate. However, before you sign on the dotted line, it is crucial to understand the complexities of commercial loan documents. These documents can be dense, filled with legal jargon, and often contain critical details that can impact your financial future.
Here’s a breakdown of the key terms in loan documents you’ll encounter and what to watch out for in each.
1. Loan Terms and Conditions
Loan Amount: Confirm the amount you are borrowing matches what you applied for and what you need.
Interest Rate: Understand whether the rate is fixed or variable. If it’s variable, know how often it could adjust and what benchmarks will affect those adjustments.
Repayment Schedule: Review the length of the loan and the repayment terms. Ensure the payment structure fits your business model—know if it's monthly, quarterly, etc. Know what happens if you miss a payment. Does the lender offer a grade period or will penalties kick in immediately?
2. Fees and Charges
Origination Fees: Understand any upfront fees that might be deducted from the loan amount.
Prepayment Penalties: Check if there are any penalties for paying off the loan early. This could significantly affect your decision if you plan to refinance or pay off the loan sooner than expected.
Late Fees: Familiarize yourself with the penalties associated with late payments, as unexpected cash flow issues could arise.
3. Covenants
Affirmative Covenants: These are actions you are required to take, such as maintaining insurance or providing annual financial statements. These may require that you maintain a minimum debt to equity ratio. Be prepared for the ongoing responsibilities these entail.
Negative Covenants: Understand any restrictions on your business, such as limitations on additional borrowing, selling assets, or altering business practices. Make sure these constraints do not interfere with your operational plans.
Financial Covenants: Financial covenants are the promises or agreements entered into by a borrower that are financial in nature. An example of a financial covenant is when a borrowing company agrees to maintain (staying above or below) an agreed ratio, typically financial ratios such as the interest coverage ratio, total assets to debt ratio, or debt to equity ratio. Financial covenants may be waived at the discretion of the lender. They can be either temporary or permanent. However, it entirely depends on the lender, and the borrowing party is usually powerless regarding the waiver decision.
4. Collateral and Security Interests
Collateral Details: Know what assets you are putting up as collateral. This could include real property, equipment, or other significant assets.
Security Interests: The documents should detail the lender’s rights to the collateral, including any consequences if you default on the loan.
5. Personal Guarantee
If your company is a small, closely-held business, there’s a good chance the lender will ask you—and possibly your partners—to sign a personal guarantee. This essentially makes you personally responsible for repaying the loan if the business can’t.
Pay special attention to:
Extent of liability: Are you liable for 100% of the loan, or only up to a certain amount? If you have partners, are all of you jointly liable, or is the liability split among you?
Impact on personal finances: Signing a personal guarantee can put your home, retirement savings, and other personal assets at risk. Consider how much exposure you’re comfortable with.
6. Default Conditions
Events of Default: Understand exactly what constitutes a default. Common triggers include failure to make timely payments, breach of loan covenants, or significant changes in your business’s financial health.
Remedies for Default: Understand the lender's rights if you default, including whether they can call the loan or take possession of collateral. Know how this might impact your business.
Confession of Judgment: Commercial loan documents routinely include this clause. A confession of judgment permits the lender to obtain an immediate judgment against a borrower for a material breach of the loan agreement. Essentially, the lender obtains a judgment against the borrower without the borrower getting the opportunity to defend themselves in court. These will also appear in a personal guarantee associated with a commercial loan.
7. Other Common Provisions
Pay special attention to:
Acceleration clause: This allows the lender to demand full repayment of the loan immediately if you violate certain terms of the agreement. Be aware of what actions could trigger this clause.
Cross-default provision: This clause can cause a default on one loan to trigger defaults on others, which could create a domino effect if you’re juggling multiple lines of credit.
Change of ownership clause: If you plan to sell the business or transfer ownership, be sure the loan doesn’t automatically come due under a change of ownership clause.
Go Into Your Loan with Eyes Wide Open
To get your loan, you will need to sign loan documents. Loan documents are contracts and, just like all contracts, the fine print matters. As the leader of your business, it’s on you to know what you’re agreeing to—not just for your sake, but for the sake of your company and your family.
Need help deciphering your loan documents? Don’t take chances with your financial future. As attorneys familiar with commercial loans, we cannot stress enough the value of professional assistance. Engaging a qualified attorney or financial advisor who specializes in commercial transactions can help you uncover potential pitfalls and negotiate unfavorabcle terms before signing.
Remember, a well-informed borrower is a powerful borrower.