Commercial Lending Basics

Covid or not, the one constant in the business world is that everyone needs a loan at some point.  Whether to start or expand a business, or just to have a line of credit with which to handle cash flow issues, virtually every business is going to have to apply for commercial credit.  With interest rates continuing near historic lows, many business owners have used the current rate situation to borrow money for expanding or starting their businesses. Toward that end, here is a list of points to consider when seeking bank financing.

1.   Develop a Relationship with a Lender.  Although it seems that more and more a credit decision is based solely on a set of financials and some algorithm, there’s still plenty of room for the old personal relationship.  As discussed below, character is an important part of whether credit will be extended.  And without letting your banker become fully informed on all aspect of your business, it’s going to be hard to make that determination.  Simply said, it’s about establishing trust on both sides – your bank needs to trust that you will meet your financial obligations and you need to trust that they will be there to meet your financial needs.

2.   Don’t Lie or Misstate Your Financial Condition.  Although this consideration is more relevant to the borrower in need of immediate money due to business problems, it applies to all borrowers. Never make any false statements in a loan application or in any documents submitted to a lender. This includes your financial statements. Be forthright in disclosing your financial condition to your lender. If you misrepresent your debts or financial condition, the law may well deem the loan as having been obtained through a fraud. In that event, the loan can never be discharged through bankruptcy. Moreover, in some situations those false statements may result in criminal liability. Even innocent “puffing” of your business may be construed as fraud if you default on the loan. As in all situations, honesty is the best policy.  Also, see Character!

3. Ask About Government Programs and the SBA.  First, as result of Covid there are a slew of different programs available to those who have been effected by the pandemic.  Some are outright grants, but others are loan programs with favorable terms.  Second, make sure to ask abouThe Small Business Administration (“SBA”).  It’s a federal government agency charged with providing financial assistance to small businesses. Although the SBA no longer directly makes loans, it provides many programs designed to assist small business owners in obtaining credit for which they might not otherwise qualify. The SBA’s primary loan program is called the “7(a)” and helps small business owners obtain bank financing by offering an SBA guaranty for a portion of the debt. In general, the loan proceeds can be used for a wide variety of purposes. Another popular SBA option is the 504 Loan Program. The 504 Program provides long term, fixed rate financing for major fixed assets such as land and buildings. These loans typically require a lower equity contribution than traditional bank financing and are made in conjunction with the involvement of entities known as Certified Development Companies - - nonprofit corporations set up to contribute to the economic development of the community. The SBA website is loaded with helpful information on these programs and the other services it provides. http://www.sba.gov/category/navigation-structure/loans-grants/small-business-loans/sba-loan-programs

4. Understand What You Are Signing.  Whether you obtain traditional financing through your bank, or through a government program, you will be presented with many different documents that must be signed. Many of the documents are familiar to all - -such as promissory notes and mortgages. Other documents are a bit more arcane.  However, there is no excuse for not reading every word of each document you are asked to sign. First, Illinois law dictates that oral statements from your lender are not enforceable when a written document creates the borrowing relationship. In other words, only the terms and conditions in the various documents control the relationship. Second, if you decide not to read so that you can later argue blissful ignorance, think again. Absent the most egregious of situations, you will be held to all of the terms and conditions in the documents you signed whether you read them or not. 

Assuming that you actually read all of the documents, you also need to make sure that you understand each and every term. Understandably, lenders want to make sure that if your business heads south that they will be adequately protected. Toward that end, many lenders require loan agreements that contain certain financial performance covenants. Failure to meet those benchmarks generally constitutes a default. The perils of not understanding such terms from the outset should be obvious.

Documents regarding collateral pledged to secure the loan should also be closely scrutinized. For example, most mortgages limit your ability to sell, pledge or transfer assets. If you subsequently pledge that collateral as security for another loan or transfer it as part of your estate planning, that could be deemed an impermissible transfer resulting in a default.  Or, if you have multiple loans at one institution, often the loans are
“cross collateralized,” which means that the collateral for loan “A” also secures loan “B” and vice versa. Understanding these terms from the outset allows you to intelligently address the issues and resolve them with your lender prior to taking a step that could inadvertently constitute a default. If you don’t understand, ask your lender or your attorney. 

5.  Five “C”s. When applying for a commercial loan, keep in mind that most lenders evaluate the so-called Five “C”s. Lenders ask (a) do you have good Character, (b) do you have the Capacity to generate cash to pay the loan, (c) do you have sufficient Capital, (d) what is your financial Condition, and (e) what Collateral can you pledge for the loan.  To assist your lender and make the process easier, be prepared to provide her with good books and records and expect her analysis to be comprehensive.

This article is for informational and educational purposes only and does not constitute legal advice.