New business owners often get so caught up in the process of finding funding, they forget the legalities that will be involved when they succeed. Some businesses will work with investors, while others may go with a bank loan. Either way, there will be agreements to sign and clauses to read.
If you’re seeking funding for your own startup, you’ll likely start with one financial institution to get an idea about rates. While finding the lowest rate will be a top priority, it’s important to carefully review the terms of the loan before signing on the dotted line. Many financial institutions will be reluctant to change the terms of the loan, especially those branches of national banks that have firm rules for loaning money.
As with anything else that requires reading the fine print, do a little research. You have the right to check multiple lenders and find the one with the best terms for your growing business. Here are a few key clauses to watch for when seeking a loan for your startup.
1. Repayment of Loan Principal
Let’s be honest, much of the decision by a business to take a loan will be based on the loan’s repayment terms. As with any loan, both the borrower and the lender should try to find a monthly payment amount that will be comfortable for the payer. In the case of a new business, this might be a little more difficult, since there may not be enough of a history to accurately determine monthly income.
Businesses can keep this payment amount in a more manageable range by choosing a repayment term that stretches it out over a certain number of years. This amount can always be adjusted with a refinance later, but businesses should also check to make sure the balance due can be paid off early without penalty.
2. Security Interest
When a financial institution issues a loan to a business, something called a “security interest” can be attached to that loan once the borrower agrees to the arrangement. The purpose of a security interest is to ensure the bank gets at least some of its investment back should the business default on the loan. This is commonly done when a business is using the loan to buy specific items, such as equipment, which then becomes collateral under the agreement.
3. Debt-Service Coverage Ratio
During the application process, a bank will carefully review a business’ debt-service coverage ratio, which is the amount of income a business has relative to its debts. Banks look for a ratio of 1.25 or more, although in tight economic times a ratio as low as 1.15 may be acceptable.
Once the loan process is complete, a business should continue to ensure its income exceeds its debt. Not only will this information be used for future loan applications, but a lender may call in a loan early if a business fails to maintain a good ratio. Before signing off on a loan, make sure you understand the lender’s terms regarding debt-service coverage ratios. Some lending institutions will require a business to report its ratio every year to remain in good standing on the loan.
This clause may be one that separates an attractive loan from one that just isn’t a good fit for you.
4. Confession of Judgment
One of the most dangerous clauses in any bank loan agreement is a “confession of judgment” provision, which many lenders require. This provision says that if the borrower defaults on the loan at any point during its term, the lender can obtain a court judgment without the benefit of a trial. This means the lender will fast-track the judgment against the borrower, with the judge automatically issuing it based on the remaining balance of the loan.
Since so many financial institutions require this provision, it may be impossible to escape it. In some states, however, a borrower can ask the judge to modify the judgment, as long as that borrower has a good defense to offer.
Businesses seeking a startup loan can often find themselves at the mercy of the lender’s contract terms. By being aware of these requirements, however, businesses may be able to compare several lenders and find one without these clauses. If not, awareness can still help businesses know exactly what to avoid, no matter how they choose to finance a business.