When an institution is considering making substantial loans to a company, it often requires, as part of the loan, agreements to control the business activities and obtain reports about the current status of the firm. Typically these arrangements include:
Limitations on the purchase of new assets – Some lenders have a policy to keep additional expenditures low after a loan has been made. This has the effect of slowing or stopping growth. Negotiate with the lender to ensure that this is not an absolute limitation on acquisition of new assets. Be sure that additional new assets can be purchased on a regular basis if there is provable growth associated with the need for those purchases. Show the lender that through planned growth, the risk of default is lessened. Planned growth can be accomplished only by the acquisition of additional assets based on a good business plan.
Limitations on additional debt – Once again, a lender may try to restrict the incurring of additional debt. This too has the detrimental effect of limiting growth. When negotiating with the lender, make it clear that additional debt may have to be incurred in order to sustain regular growth. An adequate business plan will certainly help as bargaining leverage for the execution of the appropriate terms in the lending agreement. The selling point to the lender is that additional debt supports additional income through growth. As the company grows, so does the lender’s security of repayment.
Salary restrictions – Because salaries of chief executives and other executives are a direct expense, lenders typically will want some restriction on these salaries so they do not skyrocket. Large increases in these salaries will dig into the profits of the firm, sometimes radically increasing expenses. Counter with a reasonable alternative, which may include tying the increases to the profitability of the firm. This also has the beneficial effect
of motivating management.
Dividend restrictions – If the company pays dividends, you should attempt to negotiate a reasonable formula for payment. The company is confronted with the competing interests of debt holders and holders of equity. The lender may prohibit the payment of any dividends. This allows for the additional retained earnings to be used for debt servicing. But it may have a chilling effect on the raising of additional equity capital. A company’s attraction as an equity investment opportunity is based on two factors: its absolute growth in net worth and the income stream of dividends. A no-dividends policy reduces the attractiveness of an equity investment possibility. Typically firms will be required to provide lenders with regular financial reports. Lenders generally will require financial statements accompanied by a certified public accountant’s (CPA’s) report. Audited reports certified by CPAs are costly and time-consuming documents to prepare. Look to reduce the requirement to a cheaper alternative such as a review or a compilation. Some people think that when they incorporate, they absolve themselves of any personal liability for the debt incurred by the business in its operation. Legally, that might be true.
However, lenders too have learned that people try to limit their personal liability by incorporating and often require certain personal guarantees by the business owner. Some banks may want you to sign a general guarantee of the business loan as a sign of “good faith” or as a “personal commitment” to the business. Here are some points to consider regarding collateral and loan guarantees:
- Specific personal assets – It is not wise to risk everything you own. If a pledge of “good faith” is required by the lender, pick one particular asset to risk. Do not risk more than you are willing to lose in any situation.
- The value of business collateral already offered – Typically lenders will require as much collateral as they can reasonably get. They may even seek collateral that is unreasonable. In such cases, it may be beneficial to prepare reports showing the extent and valuation of those assets pledged to secure the loan. Often appraisals by independent groups as to the value of real estate and other assets tend to dissuade the bank from seeking further collateral.
- Stock in the business as collateral – If the business has some attractiveness and a reasonably high probability of success, the lender may take back some stock as collateral. Be wary that you are not giving up so much stock that you lose control of your business.