After researching and applying for loans to help your small business grow, you’ve finally been approved! But, before you see the money in your bank account, you have to sign a business loan agreement. The business loan agreement (which often looks like this), is a legally binding agreement between you and your lender. It details the responsibilities of each party and formalizes the borrowing process. Business loan agreements often contain certain conditions and provisions, so it’s important to review the agreement, read the fine print, and ask questions so you can educate yourself and fully understand what you’re committing to before signing.
Reasons to have a business loan agreement
A business loan agreement is a two-way street; this document protects both you (the borrower) and the lender. Having a legal document that outlines conditions and expectations will help you avoid misunderstandings and guide you through the process of repaying your loan. There are many scenarios when having a business loan agreement is important:
- Starting or buying a business: If you have obtained 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, and your interest rate is dependent on factors such as your credit history, FICO score, and whether you have an underwriter. If you are giving up some equity of your company, you will want to outline this in the agreement as well.
- Buying tangible assets: PP&E stands for property, plant, and equipment. PP&E encompasses tangible assets that are not liquid, such as real estate, equipment your business needs to operate, vehicles, and inventory. When you have a loan for PP&E, defaulting or otherwise not meeting the loan conditions can result in your lender seizing these assets. For loans concerning PP&E, it is especially important to understand the conditions of the loan and make sure you are clear on penalties for late payments and defaults.
- Borrowing money (formally or informally): Even if you are borrowing from a family member or friend, having an agreement in place to detail how and when you will be repaying the loan is important, and can even save a relationship from ending over money concerns! It never hurts to have a business loan agreement in place.
Understanding what makes a loan agreement
Whether you’re reviewing a business loan agreement from a bank or financial institution or looking to draft one yourself to manage a loan from a friend or family, understanding the basic building blocks of the agreement is key. 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. The promissory note also contains the terms pertaining to the loan, including: the principal amount, interest rate, and maturity date. The note includes the date, time, and location of the signing. The promissory note is legally enforceable, and creates a legal obligation to you, the borrower, to repay the loan. You can find an example of a promissory note here.
- Security agreement: The security agreement is a document that provides the lender with a security interest, which is a specified asset or property that you (the borrower) 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 towards the amount you owe. A loan cannot be secured until you sign a security agreement; however, not all lenders require your loan to be secured, so be sure to ask your lender about this.
- Transaction information: This section states the exact amount of money you owe your lender once the agreement is effective – your principal; interest is not included in this stated amount. Additionally, this section states what you will receive in return for the money you promise to pay the lender.
- Personal Guarantee: An agreement that authorizes a lender to use your personal assets (which can include your car, house, savings, or retirement fund depending on the value of your personal assets) to pay back a loan if your business is unable to repay the loan. Personal guarantees reduce the lender’s risk, as they provide the lender with a legal right to seize your personal assets in the case of defaulting. When you sign a personal guarantee, you agree to be fully responsible for the repayment of the principal amount as well as any other costs, such as interest, that are related to the loan. This is standard practice for most lenders providing loans to small businesses.
- Payment Information: This section details how you will repay the loan, how frequently you will make payments, and what types of payment methods (cash, credit card, debit payments, wire transfer) are acceptable. Additionally, this section lays out penalties for prepayment or late payment. Sometimes, you are allowed to prepay part or all of the loan, and there is often a fee if you pay off your debt before the deadline. On the other hand, if you are unable to make your loan payments, this section identifies what the penalties are; for example, whether the penalty is a flat fee, percentage of the missed payment, or assets (personal or business) that will be seized by the lender as a form of repayment if you default on your loan.
- Affirming Statements: Finally, as the borrower, you will have to affirm that all statements are true. This usually includes statements that you are legally allowed to conduct business, that there are no lawsuits that could impact the ability for you to pay back your loan, that your business has filed and paid all taxes, and that the financial statements for your business are truthful and accurate.
- Interest Rate: This is a percentage that reflects the cost of borrowing the principal. Interest rates can be either simple or compounding. Simple interest rates are calculated on the principal amount of the loan, while compounding interest rates are calculated on the principal amount as well as previously accumulated interest (think of this as “interest on interest”). This section also tells you whether your interest rates are variable or fixed; variable interest rates change over time, whereas fixed rates stay the same over the period of time you have the loan. 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. You will want to ensure you fully understand the type of interest rate you’re paying, as payments can vary significantly depending on the structure of your interest rate.
Important terminology to know
- Amortization: Debt paid off over time through equal periodic payments made at the end of a fixed period.
- Annual percentage rate (APR): The rate reflecting the amount of interest earned or charged, plus any other fees.
- Balloon payment: The payment you make at the end of a loan term that is higher than the other installment payments you’ve been making on the loan. If you use a balloon payment, your initial payments will be lower in the beginning than when the loan reaches maturity, as the payment does not fully amortize over the term of the note.
- Co-signer: Also called a guarantor; this is the person who will assume responsibility for paying the loan if you (the borrower) are unable to make your payments. If you have a co-signer, they will need to also sign the loan agreement and are legally bound.
- Curtailment: The payment you make in addition to your regular payment to reduce the principal balance.
- Default: The failure to fulfill the conditions you agreed to when you signed the loan agreement (i.e.: failing to make payments). If you default, expect to face penalties from the lender, such as the seizing of your assets.
- Deferred payment loan: A loan that allows the borrower to make payments at a later date rather than making payment at the original due date.
- Factor rate: The decimal figure that reflects the total repayment amount. This figure is multiplied by the total amount financed in order to calculate the complete cost of borrowing. Typically, factor rates are applied to short-term small business financing, such as merchant cash advance and accounts receivable financing.
- Interest-only payment loan: A loan which you pay off by making monthly payments of just interest and then paying off the principal in a lump sum or a new loan at the end of the term.
- Loan-to-value ratio (LTV): The ratio of the principal value of the loan to the value of the asset that you are purchasing with the loan.
- Principal: The amount to be paid off that is remaining on a loan, not including interest.
- Refinancing: When you pay off an existing loan with a new loan; typically, the new loan has lower interest rates than the old loan.
- Servicing: In reference to loan management, including the collection of payments.
If you don’t understand, ask!
The loan agreement is a legal document, and a financial document – neither of which are known for being the easiest type of communications to decipher. Educate yourself to feel like you have a basic grasp of what you’re getting into, but don’t beat yourself up if you don’t feel like an expert. Anything that doesn’t make sense just ask – it’s your lender’s responsibility to you to help you make an informed and confident decision. After all, it’s in everyone’s best interests that you have a loan with terms that suit your needs, keeps your business healthy, and allows you to make payments on time.