As you know, a loan is based on a simple idea: Someone gives you money, and you promise to pay it back, usually with interest. Since you must pay back the lender whether your business is a fabulous success or a miserable failure, the entire risk of your new enterprise is placed squarely on your shoulders.
Of course, nothing in business -- or in life, for that matter -- is without risk. Nevertheless, a commercial lender will be unwilling to lend you money if it looks like there's much chance the money won't get repaid. And to help keep the risk low, a lender will very likely ask for security for the loan -- for example, a mortgage on your house so that the lender can take and sell your house if you don't keep up your loan payments.
But as compared to selling a portion of your business to investors, there's an obvious plus side to borrowing money: If your business succeeds as you hope and you pay back the lender as promised, you reap all future profits. There's no need to share them. In short, if you're confident about the prospects of your business and you have the opportunity to borrow money, a loan is a more attractive source of money than getting it from an equity investor, who will own a piece of your business and receive a share of the profits. Again, the downside is that if the business fails and you've personally guaranteed the loan, you'll have to repay it. By contrast, you don't have to repay equity investors if the business goes under.
Loans are so common that you probably are familiar with the mechanics, but nevertheless it makes sense to review the basics.
The Promissory Note
A lender will almost always want you to sign a written promissory note -- a paper that says, in effect, "I promise to pay you $XXX plus interest of XX%" and then describes how and when payments are to be made. A bank or other commercial lender will use a form with a bit more wording than our form, but the basic idea is always the same.
A friend or relative may be willing to lend you money on a handshake. This is a poor idea for both of you. It's always a better business practice to put the loan in writing and to state a specific interest rate and repayment plan. Otherwise, you open the door to unfortunate misunderstandings that can unnecessarily chill a great relationship.
Sign only the original of the promissory note. When it's paid off, you're entitled to get it back. You don't want several signed copies floating around that can cast doubt on whether the debt has been fully paid. But you should keep a photocopy of the signed note marked "COPY" for your business records. (See more on promissory notes.)
If the interest rate on the loan doesn't exceed the maximum rate allowed by your state's usury law, you and the lender are free to work out the terms of repayment.
Typically, a state's usury law will allow a lender to charge a higher rate when lending money for business purposes than for personal reasons. In fact, in several of these state laws, there's no limit at all on the interest rate that can be charged on business loans as long as the business borrower agrees to the rate in writing. In a few states, the higher limit or absence of any limit applies only when the business borrower is organized as a corporation. In other states, the higher rates permitted for business borrowers are legal even if the borrower is a sole proprietorship, partnership, or limited liability company.
Check your state usury law. As a general rule, if your business is a corporation and the terms of repayment are in a promissory note, the lender can safely charge interest of up to 10% per year and not have to worry about the usury law. But because there's so much variation in usury laws from state to state, you or the lender should check the law. Look under "interest" or "usury" in the index to your state's statutes.
Assuming there are no usury law problems, you and the lender can agree on any number of repayment plans. Let's say you borrow $10,000 with interest at the rate of 10% a year. Here are just a few of the repayment possibilities:
- Lump sum repayment. You agree, for example, to pay principal and interest in one lump sum at the end of one year. Under this plan, 12 months later you'd pay the lender $10,000 in "principal" -- the borrowed amount -- plus $1,000 in interest.
- Periodic interest and lump sum repayment of principal. You agree, for example, to pay interest only for two years and then interest and principal at the end of the third year. With this type of loan plan, often called a "balloon" loan because of the big payment at the end, you'd pay $1,000 in interest at the end of the first and second years, and then $10,000 in principal and $1,000 in interest at the end of the third year.
- Periodic payments of principal and interest. You agree, for example, to repay $2,500 of the principal each year for four years, plus interest at the end of each year. Under this plan, your payments would look like this:
End of Year One: $2,500 principal + $1,000 interest
End of Year Two: $2,500 principal + $750 interest
End of Year Three: $2,500 principal + 500 interest
End of Year Four: $2,500 principal + $250 interest
- Amortized payments. You agree, for example, to make equal monthly payments so that principal and interest are fully paid in five years. Under this plan, you'd consult an amortization table in a book, on computer software, or on the Internet to figure out how much must be paid each month for five years to fully pay off a $10,000 loan plus the 10% interest. The table would say you'd have to pay $212.48 a month. Each of your payments would consist of both principal and interest. At the beginning of the repayment period, the interest portion of each payment would be large; at the end, it would be small.
- Amortized payments with a balloon. You agree, for example, to make equal monthly payments based on a five-year amortization schedule, but to pay off the remaining principal at the end of the third year. Under this plan, you'd pay $212.48 each month for three years. At the end of the third year after making the normal monthly payment, there'd still be $4,604.42 in unpaid principal, so along with your normal payment of $212.48, you'd make a balloon payment to cover the remaining principal.
Avoid loans with prepayment penalties. Whenever you borrow money, you'd like to be free to reduce or pay off the principal faster than called for in the promissory note if you have the wherewithal to do so, since this reduces or stops the running of interest. In other words, if you have a three-year loan but are able to pay it off by the end of year two, you don't want to pay interest for year three. By law, some states always allow such early repayment, and you pay interest only for the time you have the use of the borrowed money. In other states, however, the law allows a lender to charge a penalty (amounting to a portion of the future interest) when a borrower reduces the balance or pays back a loan sooner than called for. Because it seems unfair to have to pay anything for the use of borrowed money except interest for the time the principal is actually in your hands, try to make sure any promissory note you sign says you can prepay any or all of the principal without penalty. If the lender doesn't agree, see if you can negotiate a compromise under which you'll owe a prepayment penalty only if you pay back the loan during a relatively short period, such as six months from the time you borrow the money.
Lenders, with the possible exception of friends or relatives, will probably require you to provide some valuable property -- called security, or collateral -- that they can grab and sell to collect their money if you can't keep up with the loan repayment plan. For example, the lender may seek a second mortgage or deed of trust on your house, or may ask for a security interest or lien on your mutual funds or the equipment, inventory, and accounts receivable of your business. Again, the reason for doing this is if you don't make your payments, the lender can sell the pledged assets (the security) to pay off the loan.
But it's important to realize that a lender isn't limited to using the pledged assets to satisfy the loan. If you don't make good on your repayment commitment, a lender also has the right to sue you. Typically, a lender will seize pledged assets first and then sue you only if the funds realized from those assets are insufficient to pay off the loan, but that's not a legal requirement. A lender may decide to sue you before using up the pledged assets. If the lender wins the lawsuit and gets a judgment against you, assets you haven't specifically pledged as security are at risk, as is a portion of your future earnings.
In short, before you borrow money -- under either a secured or unsecured promissory note -- think about what will happen if you run into financial problems.
Cosigners and guarantors
If you lack sufficient assets to pledge as security for a loan, a lender may try other methods to attempt to guarantee that the loan will be prepaid. One is to ask you to get someone who is richer than you to cosign or guarantee the loan. That means the lender will have two people rather than one to collect from if you don't make your payments. When asking friends or relatives to cosign or guarantee a promissory note, be sure they understand that they're risking their personal assets if you don't repay it.
If you're married, the lender may insist that your spouse cosign the promissory note. Be aware that if your spouse signs, not only are your personal assets at risk, but also those assets that the two of you jointly own -- a house, for example, or a bank account. What's more, if your spouse has a job, his or her earnings will be subject to garnishment if the lender sues and gets a judgment against the two of you because the loan isn't repaid as promised.
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