Small Business Taxes & ManagementTM--Copyright 2012, A/N Group, Inc.
Pledging stock. You may be asked to pledge the stock in your company as collateral. Depending on your ownership position, that may give the bank or other lender control of the company should you default. Try to avoid pledging stock. You'll probably have to personally guarantee the loan anyway. There's little reason you should also have to pledge the stock.
Transfer restrictions. You may be prohibited from any transfer of an interest by the present stockholders or partners. That could be a big restriction if you want to gift stock to children or relatives, or sell a portion of your interest. The longer the term of the loan, the more this type of clause can hurt. A restriction on transfer could even impact your ability to acquire another business. If the restriction is unavoidable, try to get wording that allows some portion of the stock to be transferred.
Dividend and salary restrictions. More than likely the bank will try to insert a covenant preventing you from increasing the salaries of owner/employees or paying dividends. This may not be too onerous, but you should be allowed modest salary increases each year. You may have to agree to forego dividends, but that's usually not a problem for most smaller businesses. However, it could be an issue if you've been taking money out of an S corporation as distributions rather than as a salary that's subject to employment taxes. Make sure you can live on the combination of salary and distributions before signing. There should be wording that allows distributions sufficient to pay the taxes for S corporations or partnerships.
Loan prepayment. Make sure you have the ability to prepay the loan without a substantial penalty. You may be locked into a penalty in the first few years, but fight for no or only a nominal penalty in future years. That will allow you to pay down the loan if your cash flow is better than anticipated or to refinance if rates drop.
Additional financing. You may need additional financings in the future. Be sure the loan agreement allows you to do so. In the case of debt financing, fight for a provision that allows you to borrow 50 cents for every $1 increase in your net worth. Of course, when deciding on the amount of funds you need, be sure you don't have to go back to the well too quickly. Unless you're profitable and growing rapidly, you'll have a hard time getting funds. Moreover, lenders will question your planning and forecasting abilities.
Capital expenditures. The lender will probably want to restrict your capital expenditures. Lenders know it's hard to get their money back if it's in equipment. You'll probably have to agree to some restrictions, but make sure any amount is cumulative. That is, if an amount isn't used in one year it can be carried forward and used in a later year.
Asset transfers. You may be restricted from pleging any assets for additional financing, or from the sale of a substantial portion of your assets, even if they are not used to secure the loan in question.
Other entities. If you do business through more than one entity or own other S corporations or partnerships, the lender may require the other entities to be co-borrowers on the loan. Talk to your tax adviser, accountant and attorney to make sure everyone is aware of the implications.
Ratios. There are a number of possible ratios that the lender may use for the loan covenants. You should understand how the ratios are calculated and how changes in your business could affect them. You know your business better than the lender. Two of the most common are debt to equity ratio and working capital. If you know you'll have to take a significant distribution from the business to pay personal expenses, that will lower your equity and make your debt to equity ratio look worse. Timing is also important. You may not have a problem if the lender computes the ratios only annually. That's often the case for long-term loans. Quarterly computations are often used for shorter loans or where the lender is more at risk. Just make sure you won't bust the convenants, especially early in the loan.
Tradeoffs. Read the loan agreement carefully. While you may not be in the best of bargaining positions, you should be able to make some tradeoffs. Check the restrictions in the note and identify the most onerous ones. Talk to the bank or other lender to see what he would require in a new restriction to reduce one of the existing ones in the agreement.
Do it early. This is not something to leave to the last minute. You don't want to be reviewing the agreement the day before closing. There's a good chance you'll need the counsel of more than one advisor and you may have to negotiate. You should discuss requirements right after you've been approved for the loan.
Copyright 2012 by A/N Group, Inc. This publication is designed to provide accurate and authoritative information in regard to the subject matter covered. It is distributed with the understanding that the publisher is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought. Articles in this publication are not intended to be used, and cannot be used, for the purpose of avoiding accuracy-related penalties that may be imposed on a taxpayer. The information is not necessarily a complete summary of all materials on the subject. Copyright is not claimed on material from U.S. Government sources.--ISSN 1089-1536
--Last Update 07/27/12