There are many factors to consider when negotiating business loans, and good negotiators can always tweak terms to have an advantage.
By: Hitesh Khan/
Negotiating Compensating Balances and Depositor Relationships
Some banks will require a short-term borrower to establish and maintain a specified balance in an account at the institution as a condition of the loan. For example, the bank may require you to keep at least 10 percent of the outstanding loan balance in an account.
This compensating balance (often in a low-interest-bearing account) is a way the bank makes a loan more profitable. In effect, the bank is reducing the principal amount of the loan and increasing the real rate of interest.
A compensating balance is negotiable and some banks simply request an informal “depositor relationship” with the borrower. This relationship requires only that the borrower use the bank for some other type of business, e.g., to maintain a credit card or open some type of traditional savings account. No set balances are usually required.
Negotiating business loans means trying to avoid prepay penalties
If a borrower prepays any of the principal on a loan, the bank does not get interest it expected to receive on that amount. To discourage such prepayments, some institutions will charge a fee for prepayment of certain loans (usually long-term).
It’s always to your advantage to try to reduce—or completely eliminate—any prepay penalties. But if you have no luck, at least make sure you fully understand the prepay penalties.
In addition to these direct financial costs, you should consider the indirect costs attached to the particular loan you’re considering.
For negotiating business loans, besides the direct financial costs of a business loan, you’ll also want to consider these indirect costs and conditions:
1. Considering Time Involved for Periodic Reporting
Lenders will typically require periodic reports on the status of your business. Reporting requirements on a small business loan can vary, but local community banks will probably require only quarterly and annual financial statements (your balance sheet and income statement) and annual personal financial statements and income tax returns. However, if the loan is secured by accounts receivable (or sometimes inventory), monthly reporting and aging statements on these items will be required.
The good news is that not all banks require that the reporting documents be prepared by a CPA. But even if they do, they may be satisfied if the professional has simply prepared the final compilations. Depending upon the bank’s staff and the amount of lending done, banks vary on the degree of scrutiny given to the reports.
How demanding your bank’s reporting requirements are can consume a small to a significant amount of your time. When negotiating business loans, know that the time required to find and work with a CPA is a small investment.
2. Understanding Potential Financial Covenants
Conventional lenders typically include a variety of covenants and restrictions in the loan agreement. Some banks may:
- Place restrictions on the use of loan funds
- Require proper maintenance of business facilities (e.g., insurance coverage)
- Require maintenance of key financial ratios such as debt-to-equity ratio, current ratio, and coverage of fixed charges ratio
- Dictate minimum working capital balances, restrictions on the amounts of dividend payments and salaries, mergers and acquisitions, and limits on secondary or further pledges of assets
Some smaller community banks are less demanding because they don’t want to spend the time and money policing covenants. Often, the covenants required by community lenders will limit the use of financial ratios. Instead, these lenders may include only boilerplate provisions governing maintenance of the collateral, requiring an informal depositor relationship and a subordination agreement, and restrictions on using the collateral as security for any other loans.
In reality, a wide range of covenants may not be a bad thing if your business already falls in line with most of them. But if abiding by the covenants requires major changes to the way you do business—and not arguably for the better—consider this a major cost.
3. Working with Subordinate Agreements
This agreement stipulates that all corporate obligations such as rights of shareholders, officers and directors are subordinated (made lower in priority) to the bank loan. Default of these terms can mean foreclosure on secured assets.
Nearly all small business commercial loans allow the bank to “call” the loan due if the bank feels that repayment is seriously threatened. If you’re uneasy about the subordinate language, consult a legal or financial professional to read over the loan paperwork.
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