Success of a business depends on the business owner or the financial management. Too much reliance on the lending institution to help run the business may prove disastrous. There should, therefore, be flexibility in the agreement to let the business grow and be successful. Advice and help from the lender should not be overlooked. Lenders may have had experience with other similar businesses, and you can profit from that experience. As a borrower, you should request these considerations in the lending agreement:
- There should be an option available to you to refinance at any time. Often the lender will qualify this provision to permit refinancing only after a certain period of time or with a prepayment penalty. You may need this provision in order to take advantage of lower prevailing interest rates should they occur.
- A conversion agreement should allow for more favorable loan conditions once certain “growth forecasts” have been met. This provision takes into consideration the fact that as your business grows, its risks may decrease. Because interest rates should be tied to perceived risk, as you prove your viability and success, you are entitled to pay less of an interest premium; arguably, your riskiness has been reduced.
- Agree on no prepayment penalty. Changing financial conditions may provide you with sufficient cash to prepay the loan. This may be done to realize significant tax benefits, as a requirement for the obtaining of additional financing, or to put you in a better business posture. Prepayment generally will work no hardship on the lender other than to take away the guarantee of expected future earnings. There would be nothing to stop the lender from reloaning this money to other individuals and thus recovering the future earnings from someone else. The lender’s risk is that the money cannot be reloaned at equal or better rates.
- Request limitation on interest rates. Banks prefer to charge a variable interest rate. You should negotiate limitations or caps on rates and make this a major consideration in determining whether to enter into the financing agreement. Agree on the possibility of an increased loan based on meeting certain tests. Often, if you are successful and the business is growing within certain predictable ranges, additional debt financing may be necessary to continue the growth pattern. As such, you may want the loan agreement to provide for additional advances of debt to aid in sustaining that growth. A lender should consider itself an ongoing business partner in these agreements. As you grow, so does the income of the lender. Some loans have an absolute upper credit limit, and you may borrow up to that limit without further formal application.
- The agreement should specify identifiable assets that are pledged as collateral.
- Seek a loan “grace” period of 30 to 60 days for noncompliance with debt arrangements. Very often this provision requires you to notify the lender in advance that you will use the provision. There probably will be a limit on how frequently this can be done.
Lenders may be more willing to permit minimum defaults when you submit a plan showing how you will make it up after appropriate notice to the lender. The worst thing you can do is surprise your lender. In most cases, a lender would rather work out a mutually agreeable accommodation than seek legal redress.