Jan 21 2014, 7:31am CST | by Forbes
Many entrepreneurs face an uphill battle for sufficient capital to keep a growing business in a position where it’s able to pay its employees, vendors, and landlord on time. Unless the entrepreneur has a stockpile of cash to dip into when the business experiences a cash flow hiccup, reliance on short-term financing from a bank is his first line of defense. Accordingly, many entrepreneurs establish a line of credit with their bank, in addition to permanent financing such as a commercial mortgage, and term loans for equipment and other fixed assets.
According to the National Federation of Independent Business (NFIB) Research Foundation, in recent years approximately 45% of Small Business Owners (SBO’s) have access to and use a line of credit to address the cash flow fluctuations in their business. On the surface, this would appear to be a favorable statistic. However, the NFIB also found 30% of the SBO’s reported during the annual line of credit renewal process “the terms and/or conditions of the firm’s principal credit line have been unilaterally changed by the financial institution.”
Unfortunately, when a lending officer from a bank presents the line of credit or loan documents to an entrepreneur for his or her signature, most entrepreneurs sign them and move on. In fact, the typical entrepreneur is both relieved and delighted to have access to the cash made available by the bank and doesn’t give a second thought to what may go wrong.
Bank Financing Documents Protect the Bank, Not the Entrepreneur
Banks lend money to entrepreneurs based on three factors: Cash flow, Collateral, and Credit Score. The ‘boiler plate language’ in the bank financing documents is intended to ensure the entrepreneur will maintain the business’s cash flow during the term of the agreements and to protect the bank’s collateral in case the entrepreneur fails to make required and timely payments, or is unable to pay off the line of credit and/or loan. This is accomplished in two ways. First through covenants, which are promises the entrepreneur makes to the bank; and second through clauses, which address what will happen when things don’t go as planned. In my experience, the following five bank loan covenants and clauses are those which entrepreneurs regret agreeing to the most:
Second Mortgage on Home to Provide Business Loan Collateral
Many service businesses have little-to-no fixed assets to serve as collateral and accordingly, many entrepreneurs are forced to use their personal residence as collateral. In fact, if the loan is backed by the Small Business Administration under the 7(a) program, securing the line of credit requires a personal guarantee of any equity owner with 20 percent or more ownership in the business when other assets are insufficient to fully collateralize the loan. In many cases, this means the SBA loan is ultimately secured by the equity in the entrepreneur’s personal residence.
Personal Guarantees From Husband and Wife, Joint and Several
Similar to the need to use a second (or third) mortgage on the entrepreneur’s home for collateral purposes, this covenant is used to meet the bank’s collateral and cash flow requirements. When the business does not have sufficient cash flow to support a line of credit or loan, the spouses’ discretionary personal income may be used to hold up or augment the business’s cash flow deficiency. In many cases, this covenant is required by the bank even when the second spouse does not own or work in the business. Often this covenant becomes a big problem when a divorce is pending because banks don’t like to release this covenant unless the line of credit or loan is paid in full.
Debt Service Coverage Ratio Bank Loan Covenant
To satisfy the bank’s level of risk, the bank will set forth a cash flow requirement such as a ratio of income to debt payments which must be maintained by the business throughout the term of the line of credit or loan.
For example, the bank may set a debt service coverage ratio of 1.2 which means that the net operating income for a period must exceed the total debt payments (interest and principle) payable to the bank during the same period by 20%. If the total debt payments for the period were $100,000.00, then the business would need to have income equal to $120,000.00 during the same period in order to maintain the bank’s debt service coverage ratio covenant. In many cases, the entrepreneur agrees to this covenant and does not understand its meaning or implications should the business have a year with reduced net profit or a loss.
Bank Line of Credit Borrowing Base Terms and Compliance
It’s not uncommon to have a line of credit which requires a monthly certification process in order to draw upon the line of credit or alternatively pay back the line of credit principle to the bank. This process is established by the bank to ensure the entrepreneur is not exceeding the level of risk the bank desires to assume.
For example, the bank may set forth a borrowing base formula that states the entrepreneur may borrow up to 80% of the business’s Accounts Receivable which is considered to be ‘current’. The borrowing base calculation is required by the bank to be certified by an officer of the company and delivered monthly to the bank.
Close monitoring of the Accounts Receivable in terms of its aging is necessary. Otherwise, the entrepreneur may find himself with ineligible Accounts Receivable accounts to borrow against or alternatively needing to pay down the line of credit to meet the borrowing base defined limit without the cash to do so.
Bank Loan Confession of Judgment Clause
The previous four bank loan covenants and clauses may be the source of heartache for entrepreneurs, their spouses and even their CFO’s. However, all will agree that the most problematic boilerplate language embedded in a bank loan agreement is known as the Confession of Judgment clause. Especially for the entrepreneur who finds himself in a position when all goes wrong.
Essentially, the Confession of Judgment clause gives the bank permission, in the case of loan default, to file a judgment against the business and any other individual guarantors in the loan agreement without filing a lawsuit. Ouch.
It is clearly understood that banks have the upper hand when an entrepreneur needs capital to run and grow his business. Nonetheless, it is wise to slow down when a bank lending officer presents loan documents for signature. In fact, I recommend requesting a copy of all loan documents 48 hours in advance of a closing to give the entrepreneur the opportunity to read, comprehend and seek proper legal and financial counsel.
What have you experienced as a bank loan borrower? Did you regret not reading the fine print?
Source: Forbes Business
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