How to Work Out a Loan Agreement for Your Company

When negotiating a loan arrangement for your business, there are seven crucial terms to pay attention to.

Obtaining a business loan might be intimidating. Regardless of how eager you are to sign on the dotted line and receive a cash infusion from the bank, you or your legal counsel (if you have one) should carefully analyze the loan agreement's provisions, which can have serious repercussions. I've long told clients that there's usually just one portion of a loan agreement that benefits the borrower: the one that specifies the loan's dollar amount (the loan amount)

As a general rule, expect that every remaining word of the loan agreement (also known as a credit agreement) is written to increase the bank's chances of recovering its funds. This is why lenders almost always insist on producing the first draft of the loan paperwork, which will almost certainly include boilerplate wording that is highly advantageous to them. It's up to you and your legal counsel to go over the document and work out the best feasible agreement with the bank. The following are the topics to which you should pay special attention.

Definitions

The terms of most credit arrangements will be defined. These are capitalized words that are intended to mean the same thing every time they appear in the document and are normally separated by quotation marks ("_____"). To improve the document's speed, clarity, and uniformity, most contracts use defined terminology.

These defined words are usually mentioned in a separate section of the loan agreement, either at the beginning or at the end. Before reading a single word of the loan agreement, you should study the definitions for all capitalized terms. This is so that as you read and analyze the agreement's contents, you will have a complete knowledge of what these phrases represent. Furthermore, it's probable that you'll disagree with the bank's definitions of certain phrases. The definitions of phrases like "Affiliate" or "Permitted Liens," or financial terminology like "EBITDA" or "Net Revenues," for example, could have a big impact on your various obligations under the contract.

Interest and Repayment Terms

Borrowers are usually primarily concerned with the interest rate and repayment terms, aside from the loan amount. Based on your financial capability, revenue expectations, and relative bargaining strength, it will be up to you to negotiate an acceptable interest rate and repayment period.

It's worth noting that each state has its own set of usury laws prohibiting banks from charging exorbitant interest rates. You should also be careful to negotiate a repayment schedule that is not only realistic (with some wiggle space), but also permits the company to pay off its debt as quickly as possible. Most significantly, your repayment schedule should be flexible enough to prevent you from defaulting on your loan, which could have devastating consequences (as discussed below).

Avoiding Defaults

Default events will very certainly have their own section in your credit agreement. This section should be thoroughly reviewed – numerous times if necessary. This is because breaching a loan agreement can have a wide range of severe consequences for you and your company. When evaluating the default provisions, keep in mind that you must be realistic about whether or not you and your firm will be able to meet all of the requirements (called covenants). Your credit agreement may, for example, demand your company to meet particular balance sheet ratios, submit periodic financial reports to the lender, or obtain the bank's permission before performing certain actions (for example, selling assets, creating a subsidiary, settling a litigation claim, or hiring a new senior officer).

You should heavily negotiate the substance of each covenant to the extent practicable in order to optimize your company's capacity to comply. You can also use any of the following ways to soften default provisions and covenants:

• including generous cure periods for breaches,
  
• adding "knowledge" and "materiality" qualifiers,
  
• incorporating minimum or maximum dollar limits (as applicable), and
  
• insisting that any penalties or other ramifications must immediately cease once the underlying default has been cured or waived.
  

In short, you want to take every opportunity to either delete or adjust any language in the default provisions, and the rest of the loan agreement, that could cause your company to inadvertently breach the contract and give the bank the right to assert any of its draconian remedies.

Understand the Consequences of Defaults

Defaulting on a credit deal is typically described as causing a "parade of horribles." Any default, at the very least, adds to the company's administrative cost of understanding, managing, and correcting the issue (including monitoring cure periods). You should not only defend yourself from inadvertent breaches, but you should also be aware of the consequences. In most credit agreements, the bank has the right to do everything it wants in the case of a default, including assuming possession of your stock, entering your premises, making managerial decisions, selling your assets, and so on. While persuading the lender to modify its remedies in any way may be tough, it is certainly worthwhile to give it your best shot.

Pledging Your Collateral

The lender's confidence in extending a loan to your organization is based on its assessment of your ability to repay it. Banks also safeguard themselves by requiring as much security (collateral) as feasible, which they can then lease, manage, or liquidate if a foreclosure occurs. Any cash or assets that the corporation presently holds or may be entitled to in the future can be used as collateral. Lenders frequently demand businesses to execute various security agreements (including intellectual property assignments) that grant liens on all of the company's assets, both tangible and intangible. It's also worth noting that banks frequently need your organization to have specified insurance coverages. Finally, your credit agreement may require you to have your landlord sign a waiver and permission agreement allowing the lender to access your business premises and remove all of your belongings if you default. Because landlords regularly oppose these agreements (for a variety of reasons), the lending procedure can become more complicated.

The bank may also ask for stock promises from you and other firm owners. This implies that if you default on your loan, the lender will be able to foreclose on your shares and seize control of the firm, which is obviously something you want to avoid at all costs. Also, be aware of any terms in the loan agreement (or any auxiliary documents) that provide the lender the authority to convert the company's outstanding debt into stock at any time, whether or not a default is in existence, which is even more dangerous. Always keep in mind that the last thing you want to give up is control of your firm.

Cosigners, Guarantors, and Personal Guarantees

The loan arrangement is frequently required to be guaranteed by a parent firm, subsidiary, or other affiliate. In rare situations, the bank may even ask you to sign a personal guarantee as the owner. As you might expect, doing so has a number of dangers, including the loss of limited liability protections. 

Review Ancillary Document Terms for Consistency

Depending on the lender, the company may be required to sign ancillary documents in addition to the loan agreement, such as a promissory note and the security agreements, stock pledges, and landlord waivers discussed above. It's worth noting that these documents will almost certainly have their own covenants, defaults, and other crucial terms. These auxiliary documents should also be thoroughly reviewed to ensure that they are completely compliant with the conditions of the main loan agreement. To put it another way, you don't want to find yourself in a situation where you've negotiated a softening of certain default provisions in the main contract, but then unwittingly breach more onerous default terms in a supplemental document. One solution is to have any references to defaults in the ancillary documents strictly defer to the loan agreement's default terms, with no extra explanation.

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