A business loan agreement is an understanding between a business and a lender. It documents the promises of both parties—the promise by the lender to give money and the promise by the borrower to repay that money.
Keep reading to learn more about the key aspects of a business loan agreement.
What Is a Business Loan Agreement?
A business loan, otherwise known as a commercial loan, is any kind of loan that is for business purposes. The document that outlines the details of that loan is known as a business loan agreement.
Other than the funds' intended uses, a business loan isn't much different from a personal loan. The concept still hinges on the relationship between a lender, who issues money, and borrower, who takes the money and promises to repay it plus interest. The loan agreement—whether business or otherwise—outlines how much money is being borrowed, when it will be paid back, and what the cost of borrowing money will be (interest rates, fees, etc.).
How Does a Business Loan Agreement Work?
There are several times throughout a business's life when they may seek a business loan. Occasions that could require a business to seek a loan could include:
- Entering the startup phase
- Buying a building
- Buying equipment, including company vehicles
- Buying products or parts to build an inventory
If you are getting a business loan from a bank or other lender, you will be required to use their documents and agreement forms. If you are doing a private loan with an individual, you may be tempted to use a template or a free online document.
However, there are situations in which using a free online form isn't the best idea. For example, a lack of legal experience could lead you to use the wrong online form or misunderstand your rights under a contract. You might want to use the online form as a template, but get an attorney to review it before you sign.
In business loans, as in other business contracts, each situation is unique. Everything is negotiable.
Sections of a Business Loan Agreement
Here are some of the key aspects of a business loan agreement.
Effective date: This is the date the money is disbursed to the borrower. The date you sign the loan agreement is usually the effective date.
Parties, relationship, and loan amount: The two parties to the loan agreement are described in the beginning. They should be identified in some way, like with an address, and their relationship should be defined. If there is a co-signer who is helping the business with the down payment or collateral, this person is described in the section covering the parties and their relationship. The loan amount will also be described in this section. Consider the example below.
For receipt of ____loan amount in words and numbers____, by ____name____ with a mailing address of ____address____ (the "Borrower"), agrees to pay ____name____ with a mailing address of ____address____, (the "Lender").
Promissory note or mortgage: The loan agreement may include a promissory note or a mortgage. A promissory note is basically a promise to pay; a mortgage is a specific kind of promissory note that covers a property (land and building). The promissory note may be secured by some business asset or it may be unsecured.
Collateral: If the loan is secured, then the collateral will be described in the loan agreement. The collateral on a loan is the property or other business asset used as security in case the borrower doesn't fulfill the loan. The collateral might be land and building (in the case of a mortgage), vehicles, or equipment. The collateral is described completely in the loan agreement.
Terms and conditions: This is the most important part of the loan. Since most business loans are installment loans with periodic payments, the terms include the installment agreement. Other details in this section include:
- The amount of the loan
- The length of time of the loan (usually stated in months)
- The interest rate
- Whether or not the loan may be prepaid
The interest is expressed as the annual percentage rate (APR). The terms will also state whether the interest rate is "fixed" (stays the same throughout the loan) or "floating" (changes with any changes to the prime rate).
Penalties for non-payment: The terms also include what happens if the payments aren't made on time. Each month, there is usually a grace period—a certain number of days after the due date when the loan can be paid without penalty. If the payment isn't made within the grace period, the agreement spells out penalties.
Defaults and acceleration clause: Both parties have made promises, and if one party doesn't fulfill its promises, the agreement is in default. If the borrower defaults on the loan (doesn't meet the terms and conditions), the loan agreement spells out any fines and penalties. An acceleration clause may be used as a penalty. In this case, if the borrower does not fulfill all the requirements of the agreement, the loan may become immediately due and payable.
Governing law: Business loans are subject to state laws, which differ from state to state. Your loan agreement should include a sentence about which state law governs the loan.
It's a good idea to get help writing the business loan agreement from an attorney who is familiar with local laws to ensure the agreement complies with state requirements. In addition, many states have default language that may conflict with your specific wishes.
Representations of the borrower: As the borrower, you will be asked to affirm that certain statements are true. These statements might include your assurance that the business is legally able to do business in the state, that the business is adhering to tax law, that there are no liens or lawsuits against the business that could affect its ability to pay back the loan, and that the financial statements of the business are true and accurate. These are just some common representations; there may be others for your loan. A representative of your board of directors may be required to sign this loan.
Covenants: Covenants are promises made by both parties. Most lenders will require several covenants as part of the loan agreement:
- You will need to have proof of insurance on whatever security you are pledging (a building or equipment or vehicles). The lender wants to be sure that if something happens to the asset, the insurance will pay at least part of the cost.
- Many business loans require that you buy life insurance on the life of the owner ("key person insurance") with the lender as beneficiary. The lender wants to be sure that it can have some money in case something happens to the owner.
- Another requirement is that you pay all taxes and fees associated with the asset so it doesn't fall behind. That might include property taxes and licenses on vehicles.
- You may be asked to pay expenses of the lender if the loan has to go to collections or you are in default. These might include attorney fees and collection fees.
- Some lenders require that you guarantee that the business will not take on additional debt or that your management will not change.
- For larger loans, and particularly for startups, many lenders require periodic financial statements to demonstrate that the business will continue to be able to pay back the loan.
- A business loan agreement is a document that details the key parties and terms of a business loan.
- A business loan agreement is similar to any other loan agreement, except that the borrowed funds will be used exclusively for business purposes.
- A business loan agreement outlines legal obligations, so it's important for all parties to clearly understand the terms of the agreement before signing.