After the Loan Decision

Loan Restrictions

A loan agreement defines the terms and conditions under which a lender provides capital. With it, lenders do two things: try to assure repayment of the loan as agreed, and try to protect their position as creditor. Within the loan agreement (as in investment agreements) there are neg­ative and positive covenants. Negative covenants are restrictions on the borrower—for example, no further additions to the borrower's total debt, no pledge to others of assets of the borrower, and no payment of dividends or limitation on owners' salaries.

Positive covenants define what the borrower must do. Some exam­ples are maintenance of some minimum net worth or working capital, prompt payment of all federal and state taxes, adequate insurance on key people and property, repayment of the loan and interest according to the terms of the agreement, and provision to the lender of periodic financial statements and reports.

Some of these restrictions can hinder a company's growth—for example, a flat restriction on further borrowing. Such a borrowing limit is often based on the borrower's assets at the time of the loan. How­ever, rather than stipulating an initially fixed limit, the loan agreement should recognize that as a business grows and increases its total assets and net worth, it will need and be able to carry the additional debt required to sustain its growth; however, banks (especially in tighter credit periods) will still put maximums after allowed credit, as this gives themselves another opportunity to recheck the loan. Similarly, covenants that require certain minimums on working capital or current ratios may be very difficult, for example, for a highly seasonal business to maintain at all times of the year. Careful analysis of past monthly financial statements and your growth pro forma statements can indicate whether such a covenant can be met.

Covenants to Look For

Before borrowing money, an entrepreneur should decide what sorts of restrictions or covenants are acceptable. Attorneys and accountants of the company should be consulted before any loan papers are signed. Some covenants are negotiable (however, like many elements, this changes with the overall credit economy), and an entrepreneur should negotiate to get terms that the venture can live with next year as well as today. Once loan terms are agreed upon and the loan is made, the entrepreneur and the venture will be bound by them. You probably shouldn't accept the loan if the bank:

Wants to put constraints on your permissible financial ratios

Would not allow any new borrowing

Wants a veto on any new management

Would not allow new products or new directions

Bars you from acquiring or selling any assets

Would not allow any new investment or new equipment

Personal Guarantees and the Loan

You can expect to have to personally guarantee a loan:

If you are undercollateralized

If there are shareholder loans or lots of "due to" and "due from" officer accounts

If you have had a poor or erratic performance

If you have management problems

If your relationship with your banker is strained

If you have a new loan officer

If there is turbulence in the credit markets

If there has been a wave of bad loans made by the lending institution, and a crackdown is in force

If there is less understanding of your market

The best ways to avoid personal guarantees are as follows:

Good to spectacular performance

Conservative financial management

Positive cash flow over a sustained period

Adequate collateral

Careful management of the balance sheet

Finally, if you already have personally guaranteed loans, here is how to eliminate them:

Develop a financial plan with performance targets and a timetable.

Negotiate elimination upfront when you have some bargaining chips, based on certain performance criteria.

Stay active in the search for backup sources of funds.

Building a Relationship

After obtaining a loan, entrepreneurs should cultivate a close working relationship with their bankers. Too many businesspeople do not see their lending officers until they need a loan. The astute entrepreneur will take a much more active role in keeping a banker informed about the business, thereby improving the chances of obtaining larger loans for expansion, and cooperation from the bank in troubled times.

Some of the things that should be done to build such a relationship are fairly simple.10 In addition to monthly and annual financial state­ments, bankers should be sent product news releases and any trade arti­cles about the business or its products. The entrepreneur should invite the banker to the venture's facility, review product development plans and the prospects for the business, and establish a personal relationship with him or her. If this is done, when anew loan is requested, the lend­ing officer will feel better about recommending its approval.

What about bad news? Never surprise a banker with bad news; make sure he or she sees it coming as soon as you do. Unpleasant surprises are a sign that an entrepreneur is not being candid with the banker or that management does not have the business under the proper control. Either conclusion by a banker is damaging to the relationship.

If a future loan payment cannot be met, do not panic and avoid your bankers. On the contrary, visit the bank and explain why the loan pay­ment cannot be made and specify when it will be made. If this is done before the payment due date and if you have a good relationship, the banker may go along. After all, what else can he or she do? If you have convinced a banker of the viability and future growth of a business, the banker really does not want to call a loan and lose a customer to a com­petitor, or cause bankruptcy. The real key to communicating with a banker is to candidly inform but not to scare. In other words, entre­preneurs must indicate that they are aware of adverse events and have a plan for dealing with them.To further build credibility with bankers, you should borrow before you need to and then repay the loan. This will establish a track record of reliable repayment. You should also make every effort to meet the financial targets you set for yourself and discussed with your banker. If this cannot be done, there will be an erosion of your credibility, even if the business is growing.

Bankers have a right to expect an entrepreneur to continue to use them as the business grows and prospers, and not to go shopping for a better interest rate. In return, entrepreneurs have the right to expect that their bank will continue to provide them with needed loans, par­ticularly during difficult times when a vacillating loan policy could be dangerous for a business's survival.

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