An Overview of the Legal Documents Required for a Bank Loan
If your company requires capital to either expand the business, to help survive the economic downturn, or just for security reasons, there are a number of alternatives to raising capital. For example, you can get private capital by selling equity in the company investors or you can get capital in the form of a bank loan. If you attempt to get a bank loan, there are two main types of loans, (i) a term loan, which would immediately provide the company with the full amount of the loan requested, which would be repaid over a specific period of time due each month, or (ii) a line of credit, which allows you to borrow money on an as needed basis, which would be repaid over time, and when repaid, the company could reborrow the money again on an as needed basis. During these economic times, bank loans are not easy to obtain. Furthermore, remember the difference between debt and equity financing. Debt financing needs to be repaid, which requires the Company to have sufficient cash flow.
To start the process of getting a bank loan, the bank will provide you with a term sheet to ensure the parties agree to the terms of the loan. Once completed, it will be sent to underwriting to determine whether the loan will be approved. If the loan is approved, the bank will issue a commitment letter, which states the terms and conditions under which the bank is willing to make the loan. The commitment term letter will contain certain restrictions the company must follow to obtain the loan and retain the loan. The next step is the drafting of the loan documents.
The loan documents consist of:
The Loan Agreement, which sets forth the terms of the loan as well as contains representations and warranties and covenants of the borrower. Representations and warranties are your promise to the bank concerning the company prior to the loan. Covenants are promises the company agrees to follow during the term of the loan.
The Promissory Note explains the details of the loan, such as monthly payments, interest rates, late fees and prepayment fees. The Note also describes the situations in which a bank may declare the loan in default, and require the loan to be repaid immediately. Default means the company has failed to make a payment, failed to comply with one of its covenants.
The Security Agreement describes the terms and conditions in which the bank will take a security interest in the business collateral. This provides details of how the bank can obtain your collateral in the event of a default. Generally, a bank will take an interest in a company’s inventory, accounts receivable and any other assets your business may have, including intangible assets.
A Personal Guaranty from the business owner is generally required by a bank because most small businesses have insufficient assets to secure the full amount of the loan. A personal guaranty is the business owner’s promise to repay the bank the full amount of the loan in the event the business is unable to repay the loan because the company defaults on the loan for any reason. The business owner is personally liable for the full amount of the loan and is no longer protected by the limited liability of the business entity.
A Mortgage on the house of the business owner may be required by a bank. If the small business has insufficient assets to cover the loan amount in the event of a default, and the business owner does not have sufficient liquid assets, many banks may also ask for a second mortgage on the business owner’s personal residence, which means that the bank can put a lien on a business owner’s house if the loan cannot be repaid to the bank.
A bank loan is a good source of funds if the company has the ability to repay the loan because the company does not give up equity in the company. However, it would be very expensive and risky if the company does not have good cash flow because the business owner can become personally liable for a significant liability. It is sound advice to consult with a your attorney prior to obtaining a bank loan.
Written by Louis Zambrio, Attorney at the law firm of OlenderFeldman LLP.