Securing a business loan can be a pivotal moment for any company’s growth and expansion. However, unforeseen challenges or financial setbacks can sometimes lead to loan default—a situation no business owner wishes to encounter. This article delves into the loan default process for businesses, shedding light on what to expect and offering guidance on how to navigate this complex terrain.
Understanding Loan Default
Loan default occurs when a borrower fails to meet the agreed-upon terms and conditions of a loan agreement. These terms typically include timely repayment of principal and interest and may include loan covenants that require the borrower to maintain financial stability.
Based on what professionals at FORVIS have observed, common reasons for default include cash flow issues, economic downturn, mismanagement, and changing market conditions. Inadequate cash flow creates shortfalls in the availability of cash to cover loan payments. Changes to external economic factors can negatively impact a business’s ability to repay debt, poor financial management can lead to default, and a shift in market dynamics can affect a business’s profitability and ability to service loans.
The Loan Default Process
When a borrower misses a loan payment, the lender usually sends a notice. Too often, we see businesses ignore, reduce, or stop communications with their key stakeholders when financial trouble arises. It is crucial to communicate with the lender immediately if you foresee difficulties in making payments to ensure that agreements with lenders can be reached and the facilities remain available to the business, or otherwise, discuss a change of terms. Without communication with the lender, accelerated pursuit from the bank can evolve from notices, to demands, and activation of acceleration clauses, and even legal action.
Some loans offer a grace period, giving borrowers extra time to make up missed payments, or cure covenant defaults. If the borrower remains in default, the lender may issue a formal notice of default and proceed toward collection actions. This notice outlines the specific terms that have been violated and the steps required to remedy the situation.
Many loan agreements include an acceleration clause, which allows the lender to demand immediate repayment of the entire loan balance upon default. If the borrower fails to resolve the default, the lender may initiate legal proceedings, resulting in asset seizure or a judgment lien on business assets. Often, this is pursued through a request for the appointment of a receiver.
Dealing With Loan Default
Proactive communication is paramount before and during times of default. The earlier the communication, the more options remain available. Potential solutions and outcomes to loan default include but are not limited to:
- Forbearance – In some cases, lenders may be willing to renegotiate the loan terms for borrowers who are unlikely to be able to pay their loans under the current terms and conditions. This debt restructuring is aimed at returning borrowers to a sustainable payment path by making the repayments more manageable. Banks also may consider loan deferrals, loan modifications, and even loan agreement waivers, each of which have pros and cons that borrowers need to consider before entering a revised commitment with the bank.
- Liquidating Assets – Selling assets to generate funds for loan repayment may be necessary. Prioritize non-essential and/or non-strategic assets first to maintain business operations.
- Reducing Costs – Identifying operating expenses that can be reduced or unnecessary spending that can be deferred or altogether stopped provides additional cash flow to cover loan payments.
- Consider Bankruptcy – Bankruptcy should be a last resort, as it has serious consequences for the business and its ongoing relationships with key stakeholders. Bankruptcy—while effective in stopping creditors and buying time—is only a tool, comes at an expense, and ultimately requires a viable business model to restructure and reorganize.
Consult the Restructuring and Turnaround team at FORVIS and an attorney experienced in debt-related issues to help negotiate with lenders and creditors and navigate potential litigation.
Impact on Business
A loan default can significantly impact a business’s internal and external reputation. The most common cause of loan default is a shortage of cash flow; therefore, loan defaults cause concern among creditors, suppliers, employees, customers, and other key stakeholders about their ongoing relationship with the business.
Lenders may be entitled to impose late fees and/or penalties, further impacting the cash available for normal business operations. In the event of a default on a secured loan, a lender has the right to take possession of the asset that was used as collateral.1 Usually, these assets are relied upon by the business to generate operational income, and losing the asset further impacts the business’s viability.
A history of loan default can tarnish a business’s credit score, making it more challenging to secure financing as well as future contracts with landlords, and establish credit with suppliers and vendors. Suppliers may require catch-up payments or change terms to CIA or COD, adding additional strain on liquidity and adding administrative burden.
Preventing Loan Default
It is important that the risks associated with a loan are evaluated before a loan is accepted to ensure that the business can reasonably meet the repayment obligations. Business owners and management can proactively reduce the risk of loan default through financial planning, implementing robust financial forecasting and budgeting practices, anticipating potential challenges, and having contingency plans in place.
Diversified income streams reduce the dependence on a single revenue source and can provide a safety net in case of unexpected expenses and unforeseen financial difficulties. It is vital for business owners and management to have proper financial controls in place that allow for early detection of signs leading to a potential loan default, providing management with the best opportunity to communicate with relevant stakeholders in advance to find a path forward.
Facing a loan default as a business owner can be daunting, but understanding the process and knowing how to respond is crucial. Open communication; knowing your rights, strengths, and exposures; and seeking professional advice are essential steps to take when dealing with loan default. Furthermore, businesses should focus on preventive measures to avoid falling into default in the first place, such as prudent financial planning and risk assessment. By being proactive and prepared, businesses can navigate the challenging terrain of loan default and help improve their outcomes.
How Can FORVIS Help?
The Restructuring and Turnaround team at FORVIS, including Certified Insolvency and Restructuring Advisors (CIRAs), helps business leaders see their challenges through different perspectives—and move with momentum through complex situations. Our cross-functional team, rooted in deep industry and subject matter knowledge, can assist with your organization’s challenges and prioritize close collaboration as we help create resolution during times of distress. From helping develop an in-depth business restructuring plan to facilitating critical business negotiations and implementing finite initiatives—the team at FORVIS can assist you in turning a lack of confidence and viability into new opportunities with tailored services designed to help you drive impact and change.
If you have any questions or need assistance, please reach out to a professional at FORVIS.
- 1This article does not intend to go into the nuances of judicial versus non-judicial foreclosures.