360° Coverage : Bank Loan Covenants And Clauses Entrepreneurs Regret Most

2 Updates
Bank Loan Covenants And Clauses Entrepreneurs Regret Most

Bank Loan Covenants And Clauses Entrepreneurs Regret Most

Jan 21 2014, 7:31am CST | by

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...

Filed under: news

 
 
 

39 weeks ago

Bank Loan Covenants And Clauses Entrepreneurs Regret Most

Jan 21 2014, 7:31am CST | by

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?

Learn more about Holly Magister, CPA, CFP at ExitPromise where she Helps Entrepreneurs Grow and Sell a Valuable Businesses. Follow Holly on Twitter or Google+

Source: Forbes Business

 
Update
2

7 weeks ago

Khazanah throws MAS RM6b lifeline

Aug 29 2014 5:01pm CDT | Source: Business Times Singapore

August 30, 2014 1:15 AMKHAZANAH Nasional will inject RM6 billion (SS$2.4 billion) over three years to resuscitate loss-making Malaysia Airlines (MAS) under a recovery plan that includes even an Act of Parliament. Other key moves are migrating its operations, assets and liabilities to a new ...
Source: Business Times Singapore   Full article at: Business Times Singapore
 

 
Update
1

7 weeks ago

MAS posts loss of RM307m for Q2

Aug 28 2014 5:00pm CDT | Source: Business Times Singapore

August 29, 2014 1:13 AMMALAYSIA Airlines (MAS) registered a loss of RM307 million (S$122 million) for the second quarter to end-June, but warned of worse to come in the second half when the "full financial impact of the double tragedies of MH370 and MH ...
Source: Business Times Singapore   Full article at: Business Times Singapore
 

 

Don't miss ...

 

<a href="/latest_stories/all/all/30" rel="author">Forbes</a>
Forbes is among the most trusted resources for the world's business and investment leaders, providing them the uncompromising commentary, concise analysis, relevant tools and real-time reporting they need to succeed at work, profit from investing and have fun with the rewards of winning.

 

blog comments powered by Disqus

Latest stories

Spanish nurse cured of Ebola
Madrid, Oct 21 (Xinhua) Spanish nursing auxiliary Teresa Romero was pronounced cured of the Ebola virus disease according to World Health Organisation (WHO) guidelines after the results of a second test confirmed Tuesday that she no longer had the virus in her blood.
 
 
Clinical trials of Ebola vaccine start Nov 1 in Switzerland
Geneva, Oct 21 (IANS/EFE) The World Health Organisation (WHO) announced Tuesday that it will begin clinical trials Nov 1 in Switzerland of one of the two anti-Ebola vaccines currently under development.
 
 
Colombia to launch world's first floating gas liquefaction plant
Bogota, Oct 21 (IANS/EFE) The world's first floating gas liquefaction plant is due to begin operating next year off the coast of northern Colombia under a pact between Canada-based Pacific Rubiales Energy and Belgian shipbuilder Exmar.
 
 
Paralysed man walks again after pioneering cell therapy
London, Oct 21 (IANS/EFE) A paralysed man has been able to walk again after therapy that involved transplanting cells from his nasal cavity into his spinal cord, the BBC reported Tuesday.
 
 
 

Latest from the Network

1,074 new dengue cases in Chinese province
Beijing, Oct 18 (IANS) China's Guangdong province has reported 1,047 new cases of dengue fever, health authorities said Saturday. Six people have already died in Guangdong -- five in Guangzhou and one in adjacent...
Read more on Business Balla
 
Blake Lively 'always' wanted to be mum
Blake Lively has ''always'' wanted to be a mother. The 27-year-old actress is expecting her first child with husband Ryan Reynolds and she admits she's been dreaming of this moment since she was a youngster. Speaking...
Read more on Celebrity Balla
 
Kris Jenner 'torn apart' by Bruce's new relationship
Kris Jenner feels ''torn apart and angry'' that Bruce Jenner is dating her former assistant. The 58-year-old matriarch split from the 64-year-old Olympic gold medalist last October following 22-years of marriage but is...
Read more on Celebrity Balla
 
Cheryl Fernandez-Versini won't move to France
Cheryl Fernandez-Versini doesn't want to move to her husband's home country of France. The 'X Factor' judge, 31, who comes from Newcastle, is adamant she won't be relocating any time soon to suit her new spouse Jean-...
Read more on Celebrity Balla
 
Lance Bass sets wedding date
Lance Bass has set a date for his wedding. The former *NSYNC singer and his partner Michael Turchin, who have been dating for two-and-a-half years, are to tie the knot on December 20, 2014, a representative for the...
Read more on Celebrity Balla
 
Nepal avalanche toll reaches 39
Kathmandu, Oct 18 (IANS) At least 39 climbers died while hiking on a key Nepali route after it was hit by a major snowstorm and avalanches earlier this week, BBC reported Saturday citing officials. Over 350 stranded...
Read more on Politics Balla
 
Jake Gyllenhaal says society is complicit in 'nightcrawling'
Jake Gyllenhaal says almost everybody in society ought to relate to his new movie 'Nightcrawlers'. The eagerly-awaited film concerns those people who monitor police scanners and then race to crime scenes to film eye-...
Read more on Movie Balla
 
India eves look for first win in AFC U-16 qualifiers
Dhaka, Oct 18 (IANS) India will hope to register their first win of the 2015 Asian Football Confederation (AFC) Under-16 Women's Championship qualifiers when they take on hosts Bangladesh in a crucial encounter at the...
Read more on Sport Balla
 
Moyes mulling return to management
London, Oct 18 (IANS) Former Manchester United manager David Moyes said that he is ready to revive his managerial career six months after being sacked by the 'Red Devils'. "I am ready to return. I have enjoyed the...
Read more on Sport Balla
 
Ebola fears loom over Ghana hosting AFCON
Accra (Ghana), Oct 18 (IANS) The Ghana Medical Association (GMA) cautioned the government Saturday against hosting the 2015 African Cup of Nations (AFCON), despite a request by the Confederation of African Football (...
Read more on Sport Balla