Articles, Newsletters and Advisories
(by Jayne Gest with Christian Farmakis)
It’s not always easy for business owners to find financing. Most business owners will, at some point, turn to conventional bank lending to help finance their business or fund growth, like acquisitions. There are, however, many different types of financing products available in the commercial lending market. But whatever type of financing you settle on, it’s critical to know exactly what you’re risking.
“Business owners often focus more on ‘getting the loan’ than on the specific terms and covenants of the loan, which in many instances can hinder the ongoing operations of the business,” says Christian A. Farmakis, shareholder and chairman of the board at Babst Calland.
Smart Business spoke with Farmakis about the lending environment and legal risks to keep an eye on.
What are loan options for small and mid-sized business owners?
Since the Great Recession, traditional bank lending has competed with other forms of lending. For instance, business owners are increasingly turning to private equity funding and family office lending rather than traditional, asset-based lending. These options may require sacrificing significant ownership and control over the business.
Other loan types include U.S. Small Business Administration loans backed by the federal government but underwritten by banks, small business loans for real estate financing and equipment loans.
Credit unions and regional and community banks sometimes offer different and more flexible terms and do smaller loans because they service the loan in their portfolio, where a larger bank might have stricter underwriting requirements.
What legal issues could crop up in the term sheet and loan documents?
Loans can include affirmative and negative covenants, but it’s usually the negative ones that trip people up.
Most loans require you to give a personal guarantee, provide certain information on a yearly basis, keep you from spending above a particular threshold on capital expenditures without prior approval, or stop you from taking out more debt. Most financial covenants require compliance with certain ratios, such as a debt to equity ratio; if you exceed those, the lender can theoretically default the loan. A larger loan also may require annual audits or reviewed statements, which can be disruptive and costly if the company is not already having those statements done by a CPA.
Another item to consider is pre-payment penalties, which can be significant but might decline over the first few years of the loan. It’s also not uncommon for a burdensome pre-payment penalty to stall, end or defer the business owner from doing a deal until the penalty is gone.
Therefore, it’s critical to know how the loan terms might restrict your operations and burden you with requirements. Take time to truly understand what events could trigger fees or penalties.
How much room is there to negotiate these terms?
Your negotiating room depends on the financial strength of your business, your growth model and if the bank sees opportunities to cross sell other fee-based services. Healthier, stronger businesses may be able to get items minimized or eliminated, such as fees. In addition, sometimes loans require borrowers to use services like payroll, lockbox or credit card processing. You may be able to disassociate the loan from these services.
You also want to get several quotes because banks have different underwriting requirements. For instance, one lender may require less collateral than others. And while a lot of this relates to the strength of the borrower, it also connects to the bank’s focus. If a lender isn’t interested in lending to a certain industry, it might not give the best terms.
Generally, a first-time, smaller borrower’s loan terms will be standard. You can take it or leave it, so you’re left negotiating interest rate and whether there’s a pre-payment penalty. But bigger borrowers with a solid balance sheet and strong business can prioritize the most costly or burdensome items and see if better terms are possible.
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