Small Business Questions & Answers


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Ask Toolkit About Loan Documentation

by Happy Camper | July 21, 2013

Subject :Finances

Dear Toolkit,

My banker just called with good news. They have approved my business loan application, and I am to report to the bank next week to close the deal and receive the money. Since I'll have to sign my life away, can you tell me what I need to watch out for in all that paperwork?


Happy Camper

Dear Happy Camper,

Congratulations on your creditworthiness and your willingness to consider well the promises you are about to make in writing. Most borrowers will sign anything just to grab the money before the lender has a change of mind.

You will be given many documents to autograph, all awash in incomprehensible legalese. Do not be daunted. They really boil down to some pretty basic concepts. 

Most loan documentation consists of three basic ingredients:

  • a promissory note
  • a loan agreement
  • a guaranty

The promissory note simply says that you (the maker) agree to pay the bank a certain sum at a certain time. It states the amount of principal and interest, when payments are due, what acts or omissions will cause you to be in default and what you can do to cure a default. Most defaults will be financial, failures to pay on time, but customarily they'll list a few non-financial defaults, too. Be sure you understand them. If not, ask questions. They won't charge you extra for having an inquiring mind.

The note specifies what security interest the bank will have in what collateral. For example, they'll lend you money to buy equipment but they want a lien on that equipment that says they get it if you default on the payments. This security interest is represented by a document known as a UCC-1. This Uniform Commercial Code form publicly records their interest at a state and local level.

Banks like to require security interests on all sorts of stuff from inventory to accounts receivable to your firstborn son. Sometimes they like to require a security interest on this stuff even if you acquire it long after the original loan. 

This is one thing you might want to look out for: that their security interest is confined to the equipment or inventory or whatever you're using the loan proceeds for and does not include equipment or inventory or whatever you may acquire in the future.

A promissory note also has language saying it's OK for the bank to accelerate the due date of the loan if you are in default. That is known, logically enough, as the acceleration clause

The thing to watch out for here is the number of days they give you to cure or remedy a default. Suppose you mail your payment on time but the mail truck gets hit by a bus and falls off a bridge into a river. It takes the postman two weeks to dry out your envelope and deliver it to the bank. You want the note language to say that they have to notify you of the default and give you a certain number of days after notification to send them a new check—because how could you know that truck was accidentally submerged and the mail delayed.

And in case their security interest and acceleration clauses fail, they always like to have the good old, last resort confession of judgment language in the note. (It is you who are confessing in advance that they have a right to enter a judgment against you.) This gem says that if you don't cure your default in a timely manner, they can go to court and get a judgment and take all your collateral immediately, with no further notice. You can whine about this all you want but they are highly unlikely to eliminate this clause. Bankers are devoted to this iron fist approach no matter how offensive it might be to the concept of due process. Think of it as a quaint tradition.

The loan agreement document simply says that it's OK for you to sign; that is, that you're authorized to do so for your business etc. etc. It also wants you to promise that your business is in the same or better condition on the loan closing date as you represented it to be on your initial application for the loan. And it may also indicate what kind of reports they want you to give them periodically. Certain covenants may be included requiring your business to maintain acceptable operating ratios or prohibiting you from placing other mortgages on your collateral, etc., etc.

The guaranty (guarantee) document says you, as the guarantor, agree to pledge your personal assets, including your happy home if necessary, to cover any default caused by a failure of your business to pay the loan as agreed. This is also a fine old banking tradition and you'll likely have to go along with it. But you might try negotiating a limit on the number of years your personal guarantee is really needed. Maybe you can talk them into a period shorter than the life of the loan. You don't want to tie up your home equity any longer than is absolutely necessary.

That's pretty much all there is to it. No magic, nothing to be intimidated about. Just take your bifocals and some aspirin to enhance your reading enjoyment.