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Analyzing your business loan agreement

Reading the fine printBank loan agreements will never make the best-seller list. They're filled with jargon and legalese.

But it pays to read loan fine print to avoid unnecessary costs and to ensure that you know what you're getting your business, and yourself, into when you sign on the dotted line.

Eva Rosenberg, a tax preparer and owner of the Tax Mama Web site, recalls a client who took out a loan to finance a restaurant. Her personal assets guaranteed the eatery loan.

The restaurateur subsequently decided to sell her condo to make an installment on some land she owned and buy another place while she waited to build a home on the land. Her lender told her she could. The business loan agreement with its personal guarantee clause, however, said otherwise.

Because Rosenberg's client relied on a verbal OK instead of knowing exactly what her business loan allowed, she watched the bank take all the condo sale proceeds to pay off the restaurant loan.

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The lesson: Don't listen to what anybody tells you about your loan; read the actual paperwork.

Here's what to look for:

Interest rate: Have your banker show you how the interest is calculated, whether it's based on prime or LIBOR (London Interbank Offered Rate), and whether the interest will fluctuate over the term of the loan. If so, you need to know how the sliding interest rate is calculated. Also, ask your accountant to perform similar calculations. The bottom line: Find out the total interest that you'll be paying and, when offered a choice between an interest rate based on Prime or LIBOR, which would cost you the least.

Structure of the loan: Avoid loans that are front-loaded, recommends Tax Mama Rosenberg. In this arrangement, your company will pay all the interest upfront and there may even be a penalty for paying it off early.

Borrower: Is it just your company borrowing the money or are you listed as well? What about your spouse? Banks will often try to make both the owner and the business responsible for the loan. While that makes sense for the lender, it can cost you your personal assets (home, car, etc.) should your company default on the loan.

Loan guarantees: Ah, the games that lenders and borrowers play. Lenders want to secure as many assets as they can to ensure they'll get their money back. Borrowers, meanwhile, want to keep loan guarantees as minimal as possible. If you feel like a bank is making unreasonable demands, look for another lender. Kevin Pianko, an audit partner with Richard A. Eisner & Company LLP in New York City, has a client who needs a loan and is carefully shopping for a loan that doesn't require personal guarantees. So far, he has at least one proposed lender who isn't requiring it. Follow that example and shop around.

Covenants: These are the conditions of the loan. For example, your company may be required to meet a certain ratio of debt to equity. If debt gets too high compared to equity, then your company will be in default of the loan. Make sure you can meet the covenants before you agree to the loan, Pianko says. Also understand how often the covenants will be examined: annually, quarterly or all the time and whether you can handle those requirements. "You have to see how restrictive the covenants are and whether you can work with them," Pianko says.

Assumability: Before you commit to a loan, find out if the loan is assumable; that is, if you sell the business, can the new owner take over the loan? Loan assumability can make your small business more attractive to a buyer since it will cost less and be easier to take on the existing loan rather than to get a new one, says Mike Smith, general manager of Banther Consulting, a business consulting firm in Tarpon Springs, Fla.

Escalation clauses: Although more common in credit card agreements, these can crop up in regular bank loans. "They allow the lender to raise the rate based on certain circumstances, most notably based on late payment," says Smith, a former bank officer.

Extraction clauses: Although more common with credit card agreements, extraction clauses can find their way into business loan agreements. They allow the lender to raise the interest rate based on late payment or other loan violations.

Fees: These can include charges for processing, document prep, inspection, etc. "I haven't seen a fee yet, that can't be negotiated," Pianko says. "Some fees are reasonable and some are not." Pianko currently is negotiating with a lender on behalf of one of his clients. The bank wants to charge $7,500 in facility fees. Pianko doesn't think he can negotiate the abolishment of all fees, but he believes he can get it reduced to $5,000.

Other conditions: Lenders will usually require your business to maintain its operating accounts with them or to take on other bank products. Nothing wrong with that, but try to use your business with the bank to drive down the interest rate or at least get some free bank services.

By scrutinizing these fine-print conditions, you'll have a clearer sense of your, and your company's, obligations. And the details will help you determine whether to sign on the dotted line or find another lender fast.

Jenny C. McCune is a contributing editor based in Montana.

-- Posted: June 26, 2002

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