What Is A Business Loan Agreement?
A business loan agreement is a document that describes in detail all of the conditions of a loan between a lender and a borrower. Some of the conditions detailed by a business loan agreement may include the loan amount, repayment period, repayment schedule (with specifics on minimum monthly payment, late fees, etc.), total loan costs, prepayment penalties, additional fees, and so forth. If there’s collateral involved the agreement involving the collateral should be clearly stated in the loan agreement as well.
A business loan agreement should be easy to understand and transparent while acting as the binding contract between a borrower and lender. If either party should happen to not fulfill any of the conditions outlined in the business loan agreement, then the document may be used as evidence in legal proceedings that could follow a violation of the agreement.
How Does A Business Loan Agreement Work?
A business loan agreement works by putting all of the details and conditions of the loan in writing to document the agreement and to act as a point of reference for both the borrower and the lender. The loan agreement document works as a contract between the lender and borrower where the lender gives a predetermined amount of money to the borrower upfront in exchange for a predetermined number of monthly payments that include interest and other possible fees.
Once the business loan agreement is signed, the lender can go ahead with providing the much-needed funds to the borrower who then is free to use them to fund their business operations and purchases.
What Does A Business Loan Agreement Include?
Although the contents of a business loan agreement may differ depending on the type of loan and who the lender is, most business loan agreements contain all or some of the following components.
- Promissory note: The promissory note details the loan amount, interest rate, and term of the loan. Essentially, by signing the promissory note, you are making a promise to pay back the full loan amount, plus interest, within a given period of time.
- Security agreement: Although not all loan agreements include a security agreement, if you are using collateral to secure the loan, then a security agreement is necessary. It is necessary to outline what exactly is being used as collateral and how and when a lender would be able to seize the collateral in the event of a loan default. Collateral for business loans typically consists of business property or real estate, special equipment or machinery, or merchandise or inventory.
- Interest rate: A business loan agreement will also define the interest rate that the borrower will need to pay in order to receive the funds from the lender. Interest rates are determined by a borrower’s credit history and whether or not they secure the loans with collateral.
- Potential outcomes for hypothetical situations: A business loan agreement will also outline some potential situations that may occur during the life of the loan. These potential scenarios then would result in specific outcomes that the borrower and lender can agree upon in advance. For example, what if the lender sells your loan to another financial institution? What happens with the loan? These kinds of scenarios and outcomes are typically detailed with “if this happens then this happens” statements.
- Personal guaranty: Some business loan agreements come with a personal guaranty. If a business does not have a lot of assets, for example, a new tech startup, then the owners of the business may be asked to sign a personal guarantee to secure the loan. A personal guaranty is a statement that would allow a lender to go after the personal assets of any signatories of the personal guaranty.
- Cross-default provision: A cross-default provision is for businesses that have multiple loans with one lender. Essentially, a cross-default provision declares that a default on one business loan could possibly trigger defaults on all business loans.
- Penalties: Some loans come with financial consequences for making late payments or paying off a loan balance early. For example, if you should happen to make a late payment past the grace period, the lender may charge you a late fee or capitalize your principal balance. Multiple late payments could also result in a lender being allowed to ask for payment in full immediately. When it comes to prepayment penalties, some loans may not have them. However, many lenders may like to ensure they are receiving the full amount of interest on a loan by installing financial consequences for any business that pays their loan off before the term has closed.
- Definition of default: Another important detail in a business loan agreement is the definition of default. The definition of default outlines what events or circumstances could cause the borrower to be considered in default.
Again, business loan agreements can look different depending on the type of loan and who the lender is. Because of this, before you sign any loan agreement, it is important to read everything and make sure you fully understand the terms and conditions of the loan agreement.
Additionally, it’s probably best if you review the business loan agreement with your attorney before signing. They may be able to identify any red flags or abnormal clauses that could be a cause for concern.
Last, it’s important to consider applying for business loans from multiple sources so that you can review all of the details of the various business loan agreements to help you find the best loan option for your business.
What Are The Business Loan Agreement Terms?
The terms of a business loan agreement should consist of the length of the loan repayment period, the interest rate, and the disclosure of any potential penalties or additional fees. Based on this information, a monthly payment can be calculated. This monthly payment amount may also be included in the business loan agreement terms.
What Should You Avoid In A Business Loan Agreement?
As you review loan offers and agreements, here are some red flags to be on the lookout for.
- The loan amount is too small for success: If you go into a loan application process asking for a specific amount and the lender counter offers with a lesser amount, be cautious. It may be tempting to simply grab the money offered, however, it could be setting your business up for failure. Not receiving enough financing to accomplish the things you need to do to establish a successful operation can leave you shorthanded. Whether that's not being able to purchase all of the machinery you need or hiring a sufficient number of qualified employees, not having the means necessary to make your business a success can prove to be detrimental.
- Repayment period is longer than the life of the equipment being financed: Loan terms for equipment financing or business loans secured by machinery as collateral should never extend beyond the life of the equipment being financed. This is a major red flag that should have you and your lawyer renegotiating with a lender or seeking financing from an alternative source.
- No details of early payoff included: Even if a lender charges a specific penalty for paying off a loan early, they should disclose that information upfront. If there are no early payoff penalties, great. However, that should be detailed in a business loan agreement as well. Having no language describing what happens if a loan is paid off in full early can be a red flag.
- Fees are mentioned as an afterthought: Any and all fees that a borrower may need to pay on a loan should be explicitly defined in the business loan agreement. This can include application or document fees, origination fees, balloon payments, and any other charges that may occur over the life of the loan. The language should be concise and easy to understand.
- The loan agreement is different from what you discussed: When you first are applying for business loans, make sure to keep the loan offer on hand so that you can compare it to the actual business loan agreement. If there are discrepancies, it could be a sign that your lender is operating in bad faith, or it could have been an honest oversight. Either way, you will want to comb through the business loan agreement carefully with your lawyer to make sure that the loan agreement is what you were promised.
Is Getting A Business Loan Agreement A Good Idea?
Business loans can help businesses succeed and grow. As long as your business can handle the business loan, it should result in a good idea. However, if there’s no plan and funds are not properly managed, you may encounter some obstacles. Consider the best case and worst case scenario before making any decision. You should prepare for the worst but expect the best.
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