Before applying for a small business loan, it helps to understand the business loan agreements that make a loan’s growth-fueling cash influx possible.
A business loan agreement is a document that creates a legally binding contract between your small business and its money lender. As a legal agreement for lending money, it explains your financial obligations for using and repaying the money you’ve borrowed to underwrite your enterprise.
To help you feel confident about your rights and responsibilities as a loan recipient, let’s break down the inner workings of a business loan agreement and when you need one.
What is a business loan agreement?
As mentioned, a business loan agreement legally binds you and your lender. It details the responsibilities of each party and formalizes the borrowing process. The U.S. Securities and Exchange Commission (SEC) has a sample agreement template that you can view and download.
Business loan agreements contain specific conditions and provisions, so it’s important to carefully review individual contracts, read the fine print, and ask questions to educate yourself. This way, you can fully understand the business loan contract you’re committing to before signing.
How does a business loan agreement work?
Whether you’re examining a business loan agreement from a bank, a Small Business Administration (SBA) loan agreement from a financial institution, or drafting one to manage a loan from a friend or family, it’s critical to understand the essential parts of the agreement. The following components are part of almost all loan agreements.
- Promissory note — A financial instrument that contains a written promise by one party (you, the borrower) to another party (your lender) to pay a stated sum to the lender by an agreed-upon date. A loan agreement between companies defines the loan terms: the principal amount, the interest rate and the maturity date. Your interest rate is dependent on factors such as the type of loan you have, your credit score, and whether or not the loan is secured or unsecured.
- Security agreement — A document that provides the lender with a security interest, a specified asset or property you own and agree to use as collateral to secure your loan. If you default on your loan, the lender can seize the collateral and use it as a form of repayment toward the amount you owe.
- Transaction information — This section states the amount of money you owe to your lender once the agreement is in effect (your principal). This stated amount does not include interest. Additionally, this section states what you will receive for the money you promise to pay the lender.
- Personal guarantee — An agreement that authorizes a lender to use your assets to pay back a loan if your business cannot repay the loan. These can include your car, house, savings or retirement fund, depending on the value of your personal assets. When you sign a personal guarantee, you agree to be fully responsible for the repayment of the principal amount and any other costs, such as interest, related to the loan.
- Payment information — How you will repay the loan, how frequently you will make payments, and acceptable payment methods (cash, credit card, debit payments, wire transfer). It also lays out penalties for prepayment or late payment. For example, there is often a fee if you pay off your debt before the deadline. Or, the lender could seize your assets if you are late or default on your loan.
- Affirming statements — As the borrower, you must verify that all statements are factual. Common statements include:
- Our legal ability to conduct business
- That there are no lawsuits that could impact your ability to pay back your loan
- That your business has filed and paid all taxes
- That the financial statements for your business are truthful and accurate
Who needs a business loan agreement?
Whether working with a financial institution or accessing the Bank of Mom and Dad to help launch your dream company, a business loan agreement is essential. That way, you’ll have a legal document outlining the conditions and expectations to help you avoid misunderstandings and guide you through repaying your loan.
These agreements are critical in many different circumstances, especially if you are:
- Starting or buying a business – If you obtain a loan from a traditional lender, you will have a standard loan agreement detailing how and when you will pay back the principal loan amount and any accrued interest. Traditional lenders, such as banks, typically have more stringent conditions, so pay close attention to this business loan agreement.
- Buying tangible assets – When you have a loan for PP&E (property, plant and equipment, which includes physical assets such as real estate, business equipment and inventory), defaulting or otherwise not meeting the loan conditions can result in your lender seizing these assets. Know the loan conditions and penalties for late-payments and defaults.
- Borrowing money, either formally or informally – Even if you borrow from a family member or friend, it’s valuable to have an agreement to detail how and when you will repay the loan. More importantly, it can even help prevent a relationship from ending over money concerns. It never hurts to have a business loan agreement in place.
Example situations of a business loan agreement
There are always strings attached when borrowing money, so it’s good to know the ground rules before making your first inquiry. The desire to get an influx of cash to help grow a small business is, after all, one of the great struggles of entrepreneurs — witness the success of shows like Shark Tank.
Whether you’re buying equipment for a lawn care company, starting a food truck, or investing in marketing software, a business loan agreement will help you better understand all the details related to repaying the borrowed sum.
Small businesses will often need to sign a business loan agreement to enable expansion plans, keep the cash flowing during a seasonal slowdown, or because they want to circumvent slower cash-growth methods such as a long sales process.
Protect your hard work
It’s your lender’s responsibility to help you make an informed and confident decision. It is in everyone’s best interests that you have a business loan agreement with terms that suit your needs, keep your small business healthy, and allow you to make payments on time. If you’ve read the fine print and still have questions, don’t hesitate to speak up to your lender.
You should also consider the value of a professional liability insurance policy. Also known as errors & omissions insurance, it financially protects you from the impact of claims that you failed to provide your professional services appropriately, causing monetary or reputational damage.
You’ve already taken the proper steps to educate yourself before signing for a business loan. Thimble can help steer you in the right direction with professional liability insurance. Simply download the Thimble mobile app or click “get a quote,” answer a few questions and get insured within minutes.
