A business loan agreement documents your obligations when you’re borrowing money from a lender, whether that be a bank, family member or nontraditional lending platform.
Make sure you understand the loan agreement before you sign it: It’s a legal contract that establishes when and how you must pay off your debt and the penalties you’ll pay if you don’t.
You’ll need to sign a loan agreement contract when you borrow money for any type of small business need, including:
After you’ve shopped for a small business loan, undergone the underwriting process and received a financing offer, it’s time to sign the loan contract. Before you do, you need to educate yourself on what you’re signing.
Traditional banks and nonbank, alternative lenders will present you with an agreement in their own preferred format. If you’re borrowing from friends and family you can find a loan agreement template online and customize it. Although institutions might use varying terms or different structures to organize information, the components of all loan agreements are generally similar:
A promissory note is a legally binding promise to pay back the money you are borrowing. Some loan agreements incorporate this promise into the language of the loan agreement; others break it out as a separate document.
If you’re securing a loan with assets, the loan agreement will include a security agreement describing the items, called collateral, that the lender will be able to seize if you default on payments. Collateral can include property, equipment, merchandise or bank accounts.
The loan agreement states the interest rate associated with your loan. Several factors influence the rate, such as the collateral you offer, your credit score as a borrower and the length of the loan, as well as prevailing market rates.
Shop around — using prequalification when available — to see what terms and interest rates are available to you. Ask lenders how you might get a lower rate, for example by offering a personal guarantee, shortening the payoff period or switching to a floating rate loan.
The loan agreement should clearly spell out “if this happens, then that happens” for possible issues that may come up during the life of the loan. These statements must be very explicit and well explained to protect you from nasty surprises.
A loan agreement should also outline what happens if things change in either your business or the lender’s. For example, what happens to your loan if you sell or shut down your company? How are your terms affected if the lender sells your loan to another institution?
Critical aspects of business loan agreements are often buried in the fine print. Here are a few examples.
Lenders frequently ask you and your co-owners to sign a personal guarantee for a loan to your sole proprietorship or LLC. A personal guarantee gives the lender the right to seize your personal assets, possibly including your home, cars and bank accounts, if the business doesn’t pay back the loan on the agreed upon terms.
Even if your business is set up as a corporation or limited liability company to reduce your personal liability for its operating activities, signing a personal loan guarantee puts your assets on the line for loan defaults.
A cross-default provision applies if you have multiple loans with the same lender. Defaulting on one loan could trigger default penalties on all of those loans.
There may be times you’d like to pay off all or part of your loan early because you have extra cash on hand or have found a new loan with better terms. Depending on the provisions of your loan contract, you could face a prepayment penalty or additional fees for paying off the loan early.
The loan agreement will specify late payment penalties like fees, interest rate adjustments and capitalization of interest (interest charged on your unpaid interest). If there’s an acceleration clause in the loan agreement, repeated late payments could even allow the lender to terminate the loan and require immediate repayment in full.
Default is failure to fulfill promises made in the loan agreement. Financial defaults occur when loan payments are late or skipped. Technical defaults pertain to lapses on other loan requirements like providing copies of your annual tax returns, maintaining your facilities or keeping a certain amount of cash in the bank.
Loan agreements describe exactly what events will trigger a default and what the consequences will be, which are called remedies. The list detailing the loan requirements and remedies is called the loan covenants.
NOTE: Your state may have unique lending laws regulating what lenders must disclose in loan contracts, maximum interest rates they can charge and other aspects of small business loan agreements. Search the internet for state lending regulations or consult with an attorney to get details.
If you’ve pledged assets as collateral for your business loan, the lender will likely make a UCC-1 filing publicly declaring its right to take those assets if you default. This is also called a UCC lien. It may list specific assets or, if it’s a blanket lien, may lay claim to all your company’s assets, including inventory, accounts receivable, vehicles and equipment.This can even include future assets that you don’t own yet.
Assets listed in a UCC lien can’t be used as collateral for other loans or sold without the lender’s permission. Since UCC liens show up on your credit report they may hamper your ability to get additional funding because potential future lenders know that others have first dibs on your assets, which increases their risk of lending to you.
Here are some additional commonly used terms that are important to understanding loan agreements:
Once you decide to get a business loan, there are a few steps to take before signing the agreement:
If you’d like to see an example of a business or LLC loan agreement, or want to draw up a contract to use in borrowing from friends or family, search online for a template. LawDepot provides free business loan agreement templates that you can customize based on your state and transaction details.
Before using your own loan agreement, be sure to have a business attorney review the document. Or you might opt to hire a lawyer to write the contract. Mistakes in a loan agreement could result in unwanted consequences for both the lender and the borrower.
A commercial lender won’t likely allow much room to negotiate terms of their business or LLC loan contract. Before signing the loan agreement, look out for these red flags.
If your interest rate is adjustable, the percentage may rise during the life of the loan. A fixed interest rate may start out higher, but gives you assurance that it won’t change over time.
Before you enter into a loan agreement, consult your business plan to see if it’s realistic that you’ll have the money you need to pay off the loan plus interest. You should also imagine a scenario in which you can’t make payments and how that would impact your business and daily life.
When carefully reading the business loan agreement you may notice a term or provision that you don’t recall discussing with the lender. Don’t ignore it: Get clarification on anything you didn’t expect to find. Once signed, the loan contract is legally binding whether you understood it or not.