So you have finally completed your business plan and presented it to the bank for a small business loan. Hurrah! The bank takes the view that risks have been sufficiently mitigated and the forward strategy and sales projections you diligently illustrated in your plan meet the credit parameters for loan approval. Joy!
You may be tempted to think that the hard work is completed. While this is true to a certain extent there is one last hurdle that must be completed. Namely, negotiating the best small business loan terms possible for your business.
The bank will present a loan document that more often than not will be skewed heavily in their favor. Even though you have overcome the major hurdle of getting them to say “yes”, they will still look to shore up the risk profile of any loan with a few sneaky conditions that protect them from downside risks in your business model. They are a fickle bunch when it comes to lending money and you need to be on guard and understand how to get the best loan for you and your business. Let’s take a quick look at the salient points you should look out for before you sign anything.
Negotiating Fixed Small Business Loans
Small Business Loan Tenor (Loan Maturity)
In most cases you will want the longest term possible on a small business loan for the following reasons:
- It provides funding security in a rising interest rate environment.
- It allows you to plan and be secure that your cash flow is supported.
- It decreases refinance risk and limits establishment fees in the near term
Conversely the bank will want the shortest term possible on a small business loan for the following reasons:
- A short maturity provides a credit trigger to review the loan and your business.
- There will be more opportunity to refinance and charge fees.
- A shorter maturity decreases the likelihood of the bank being stuck with a loan that is underperforming.
The key to negotiating this term is to understand your business risks and be prepared to have a robust discussion on the rationale for a longer term maturity. Link the rationale to your cash flow forecasts and demonstrate serviceability for the longer term and also provide a scenario analysis illustrating the point at which you will not be able to service the loan. Assuming you can make a strong case the bank may be willing to relent on this.
If you manage to secure a longer maturity date the bank will in most cases insert a clause know as a call provision. This is a clause which permits the bank to demand full repayment of the loan in the event that your business fails to meet the covenants or terms of the loan. This is a clause that is pretty much non negotiable as the bank must have the ability to demand repayment if the small business loan is in default. This doesn’t only relate to servicing interest, it can also be extended to financial covenants based on business performance such as Interest Cover Rate.
Interest Cover is a financial metric that measures how many times your cash earnings can pay interest on the loan. The higher the better for banks because it provides a more substantial buffer to mitigate serviceability risk. These covenants are your best opportunity to negotiate effectively. Using the same tactics as with the Loan Maturity make a case for less stringent covenants. Interest Cover Rate to be 2 times interest rather than 3 times, for example. This lessens the restrictions on your cash flow and dilutes the power the bank has over your cash flow position.
This clause allows the bank to charge a fee for early repayment of the small business loan. Sounds ridiculous given they will be paid back i.e. elimination of all risk to them. However, there are more sinister motivations in play here. The bank doesn’t want a profitable business to repay loans early. It may eliminate risk but it also eliminates trailing income in the form of interest payments. This clause is the bank’s attempt to preserve the return on equity they get from lending you money.
Make no mistake that if interest rates rose sharply, which they probably will given we are in record low interest rate territory, you may want to repay a loan and you should preserve the right to do so as it is in the best interests of your fiscal position. This clause is the most readily deleted if a strong case is presented, as it is no longer consider “market” in the small business space. You may find that successful deletion of this clause will result in a higher initial rate with no discounts. Again, the bank is trying to make as much money out of you as possible so be aware.
What is the Most Important Factor?
It really depends on your business and what you value most. If you value flexibility then perhaps you can live with a higher initial rate. If you are price sensitive and can handle being “locked in” to a certain extent then perhaps you will go hard on the rate and sacrifice the other terms. You won’t get everything your own way and your negotiating position will be predicated on the strength of your risk profile and how compelling your case is. Nonetheless it is wise to be aware that banks can and will be flexible toward clients that are attractive to them.
You can also strengthen your bargaining position by highlighting cross sell opportunities to the bank in the form of transactional banking and insurance requirements, for example. Banks are massive organisations and your small business loan is only one of the ways they gain economic benefit. The net worth of a client across all business divisions can make a material difference when it comes to negotiating the terms on any loan.