5 red flags to consider before signing a business loan contract

In July 17, 2017

Construction Loan red flags, lifesaver imageDiscovering terms of a loan are unfavorable AFTER being locked into a contract is never a happy circumstance. It’s easy to be hurried, assume the contract mirrors something said in conversation, or gloss over a detail we don’t understand. It’s also common to have details from a templated contract sneak into places it doesn’t belong.

A seemingly small overlooked detail can have incredible impact on a business and when it comes to financing, we often move faster in the long run by slowing down.

Being intentional, in the moment and carefully considering details makes a difference, and occasionally the liberal use of a pencil to mark up a badly written contract is a lifesaver.

So what kind of red flags deserve a closer look?

1. The term of the loan or payment schedule isn’t exactly what you expected. Are payments due monthly or weekly? Is the timing and amount what you’ve discussed with the lender? Is the contract language something you’re comfortable with, or is there an area that might need clarification? It’s important to compare what you’ve been promised and what you discussed to the actual contract. If they don’t match up, the discrepancies are cause for alarm and should be discussed.

Even a comma in the wrong location can completely change the legal implication of a sentence, so it’s important to read it slowly and carefully, and don’t ignore errors or grammatical issues. 

2. Fees are left out of the contract, or vaguely worded. Are there any unexpected fees, such as application fees, documentation or origination fees, or a balloon payment at the end of the loan? It’s wise to ensure there are no surprises and that you understand exactly how much is due when. All fees should be outlined in the contract, along with the specific amount of the fee and when each one might apply.

Take a look at the timing, too, so you’re confident it fits in with your expected cash flow. Are fees due at the same time you’re paying for seasonal merchandise, straining cash flow? Might the balloon payment interfere with another looming purchase, such as big-ticket equipment or commercial real estate? Are there incidental expenses other than the loan, such as interim rent?  If you refinance a balloon payment, will you need another down payment at closing? Thinking through the long-term implications of the loan and how it might overlap future plans and expenses can identify potential conflicts or cash flow issues. It’s better to know this before committing to the transaction.

3. There’s no provision for early payoff. Even if you don’t think it’s likely, it’s important to discuss what happens if the loan is paid off early, and ensure the contract addresses it satisfactorily. Are there penalties for early payoff? How will the payoff amount be calculated and what interest or fees might be added? Are any fees refundable if the loan is paid off early on specific milestones?

4. Payment terms are longer than the life of equipment financed. This one is most applicable to an equipment loan or purchasing seasonal inventory, but it can be problematic when loan payments outlast use of the equipment or sales of the inventory.

Who wants to start payments on new equipment while paying off the old, or be paying off holiday merchandise when summer arrives? It ties up cash flow and creditworthiness, and potentially gives a lender doubt the borrower can comfortably take on more debt.

If this kind of situation can be prevented by matching up loan terms with the lifespan of the equipment or sales cycles, it protects both the lender and borrower.

It’s also something most bankers avoid, so overlap of this nature can signify an over-eager lender focused on closing loans with little regard for the borrower’s best interests.

5. The loan amount is dangerously conservative. Nobody wants to borrow more money than they need, but it’s also common for loans to be too small, setting up a business for failure with the lack of financial breathing room.

Before finalizing a contract, it’s valuable to take another look at the calculations and intended use of the borrowed funds to be sure the loan amount is large enough.

Interestingly enough, this shortfall can sometimes be related to gender gap. According to this Forbes article, women entrepreneurs ask for less financing than men, and receive smaller loans at higher interest rates.  For either gender, anxiety about payment affordability can lead to signing off on a loan that is restricting rather than helpful, and most lenders are happy to discuss this in great detail, and even take a closer look at business operations to ensure right financing.

This works in the lender’s favor, since it costs roughly the same amount to process each loan, regardless of its size. Incremental increases to the borrowed amount that gives the borrower necessary breathing room is a boon for their profit margin, so they often welcome the conversation.

Consider legal counsel

As a final closing note, it’s never a bad idea to have a lawyer review financial contracts, just to be on the safe side. They’ll catch red flags the average person would completely miss. And while we can’t provide legal advice and nor should this article be construed as such, we’re happy to provide a no-obligation review of any financing contract to compare terms and point out how it is different from ours.

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