Banks are the largest small business lenders and probably the first place you think about when getting a loan. They offer some of the lowest cost loans, but qualifying can be difficult; about 72% of small business owners who apply get rejected. Banks usually require strong personal and/or business credit scores, a personal guarantee, collateral, and healthy financials. Applying also takes significant effort and time — completing the process can take from one to three months.
Traditional Bank Loans: Covenants
Before taking a traditional bank loan, it is important to clearly understand any covenants associated with the loan and the collateral required to secure it. Covenants are clauses in lending contracts that may restrict or limit you as the borrower from using the money for certain things, or require you to adhere to particular business performance requirements. The level of constraint or number of requirements is primarily based on the risk of the borrower, as determined by personal or business credit score, payment histories, and overall business financials.
Covenants protect a lender by ensuring that a loan will be paid back, no matter the circumstances of the business. A thorough understanding of any covenants attached to a loan can help you avoid violating a covenant and facing the severe consequences that can result. For instance, using your loan for anything outside of the agreed-upon terms, even in emergency business situations, can constitute breach of your loan agreement, as can taking on new loans or accepting funding without the bank’s permission.
The consequences of violating bank covenants, can include the bank calling back the note, pulling your credit line, and/or forcing you to pay the entire amount back within a shorter time period (sometimes within as little as 30 days). A bank may go after your business and even your personal assets to repay a loan (since personal guarantees are often included in loan terms).
Before signing your agreement:
- Carefully read your loan agreement
- Ask for clarification on anything you do not understand
- Consult a trusted advisor such as your CPA or attorney
- Confirm whether adhering to any covenants is realistic
- Make sure you know if you are signing a personal guarantee
- Ask the right questions about your loan agreement