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

 
 
 

35 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

4 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 company (NewCo) and slashing the workforce of 20,000 by ...
Source: Business Times Singapore   Full article at: Business Times Singapore
 

 
Update
1

4 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 MH17 ...
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

'India is reaching for the stars under Modi'
Washington, Sep 28 (IANS) As Prime Minister Narendra Modi took to the world stage with a stirring address to the UN general assembly, an influential US daily noted how Modi once unwelcome in US was getting a "rock star" reception.
 
 
Liberia's chief doctor under Ebola quarantine
London, Sep 28 (IANS) Liberia's chief medical officer has put herself under quarantine for 21 days, after one of her assistants died from the Ebola virus.
 
 
Modi hails global citizens for sanitation
New York, Sep 28 (IANS) From the ramparts of the Red Fort Aug 15, Prime Minister Narendra Modi Saturday took his message of sanitation to New York's iconic Central Park, hailing people gathered there who are part of Global Citizen, a website network of people fighting lack of sanitation and poverty across the world among other pressing issues.
 
 
This is time to help flood-ravaged Kashmir, Modi tells Pakistan
United Nations, Sep 27 (IANS) Taking a swipe at Pakistan for raking up the Kashmir issue, Prime Minister Narendra Modi Saturday said that this is the time to provide succour to people of flood-ravaged Jammu and Kashmir, and India had offered help with flood relief to Pakistani Kashmir.
 
 
 

Latest from the Network

Messi joins 400 club as Neymar hits hat-trick
Madrid, Sep 28 (IANS) Lionel Messi scored his 400th professional goal and Neymar scored a hat-trick as FC Barcelona had an easy 6-0 win at home to Granada. A tight opening to the game Saturday was broken when Neymar...
Read more on Sport Balla
 
Brazilian officials hail FIFA player ownership overhaul
Rio de Janeiro, Sep 28 (IANS) Brazil's sports ministry has welcomed a move by FIFA to ban third-party ownership of players. The widespread practice is set to be outlawed within four years, FIFA president Sepp Blatter...
Read more on Sport Balla
 
I would love to be a father one day: Bradley Cooper
London, Sep 28 (IANS) Actor Bradley Cooper, who is dating model Suki Waterhouse, says he is ready to be a father. In an interview with Square Mile magazine, the 39-year-old actor revealed how being a father is his...
Read more on Celebrity Balla
 
Bayern extend their lead, Schalke beat Dortmund
Berlin, Sep 28 (IANS) Bayern Munich cruised to a 2-0 win over newly-promoted Cologne while Schalke beat Borussia Dortmund 2-1 at the 145th "Revierderby" in the German Bundesliga. Bayern extend their lead in the...
Read more on Sport Balla
 
Jones among stars called up for Caribbean Cup qualifiers
Port of Spain (Trinidad), Sep 28 (IANS/CMC) Cardiff City striker Kenwyne Jones leads an array of international stars called up for Trinidad and Tobago's Caribbean Cup campaign starting here next month. Jones, who has...
Read more on Sport Balla
 
Dottin shines again but Windies lose in super over
Kingstown (St. VIncent), Sep 28 (IANS/CMC) A splendid half-century from Deandra Dottin was not enough as the West Indies women went down to New Zealand women via a tense super over, to concede their three-match...
Read more on Sport Balla
 
Jamie T finds live shows a strain
Los Angeles, Sep 28 (IANS) Singer-songwriter Jamie T enjoys playing live but finds gigs take a toll on his health. The 28-year-old, who has recently returned from a four-year hiatus, finds it difficult to meet people'...
Read more on Celebrity Balla
 
Russell Brand enjoys a date with mystery woman
London, Sep 28 (IANS) After a reported split with Jemima Khan, comedian Russell Brand was seen enjoying dinner with a mystery female friend here. The 39-year-old dined out at Covent Garden's restaurant Balthazar with...
Read more on Celebrity Balla
 
Modi hails global citizens for sanitation
New York, Sep 28 (IANS) From the ramparts of the Red Fort Aug 15, Prime Minister Narendra Modi Saturday took his message of sanitation to New York's iconic Central Park, hailing people gathered there who are part of...
Read more on Business Balla
 
Pattinson troubled by sweat during intimate scene
Los Angeles, Sep 28 (IANS) Actor Robert Pattinson says he sweated like a "crazy person" while filming an intimate scene with co-star Julianne Moore for "Maps to the Stars". In an interview with Heat magazine, the 28-...
Read more on Celebrity Balla