The Insider's Guide to Business Loans

If you're looking for a business loan, be sure you know the essentials.

A loan, as you may know, is based on a simple concept: someone lends you money in exchange for your commitment to repay it, generally with interest. Because loans are so prevalent, you're undoubtedly acquainted with how they work, but it's still a good idea to brush up on the basics. Borrowing money wisely can make or break your business: you want to borrow enough to help your firm reach its full potential, but not so much that you have trouble repaying it

Putting too much money into your business in the start might be a mistake. Because many small businesses fail within their first year, raising and spending a large sum of money on an unproven company plan can cause a lot of trouble — especially if you're personally liable for borrowed cash. Consider beginning small and on a shoestring budget.

Types of Lenders

When it comes to getting a loan for your business, you have a lot of alternatives. Friends and family members are occasionally willing to assist with modest projects. Banks, credit unions, and savings and loans may be ready to lend money to smart or mid-sized firms. See Small Business Loans: Getting the Lender's Approval for advice on securing a loan from one of these institutions. Many state and local governments, as well as the US Small Business Administration (SBA), provide financing programs to help small firms develop. See www.sba.gov/financialassistance for a great primer on loans and lenders.

The Promissory Note

A lender will almost always want you to sign a written promissory note, which essentially states, "I commit to pay you $XXX plus X% interest."

While a friend or family may be ready to lend you money on the condition that you sign a handshake agreement, this is a poor idea for both of you. It's usually a good idea to put the loan in writing and specify a precise interest rate and payback schedule. Otherwise, you risk unintentional misunderstandings that might suffocate your relationship. In case the IRS decides to audit your firm, you'll also want to have evidence of the loan's conditions.

Interest

State usury laws make it unlawful for lenders to charge unreasonably high interest rates on loans. As a general rule, a lender can charge you interest of up to 10% per year without breaking the usury law. However, usury regulations vary greatly from state to state, and various restrictions apply to commercial and private lenders, so if you're worried, you should examine your state's law. In your state's statutes, look for interest or usury.

If your company takes a loan from a shareholder (including yourself), be sure the interest rate is not excessively low; the IRS prefers commercially acceptable loans. Otherwise, the IRS may classify the loan as a capital investment by the shareholder, and the loan repayments as dividend payments.

Security Interests

If you don't make your loan payments, many lenders may ask you to put up valuable property (referred to as "security" or "collateral") that they can sell to recoup their losses. A lender may, for example, ask for a security interest or lien on your business's equipment, inventory, or accounts receivable, or a second mortgage or deed of trust on your home.

Personal Liability

A lender has the authority to sue you individually (whether your business is a sole proprietorship or general partnership) or sue your business organization if you don't make good on your repayment obligation, depending on how your firm is formed (if your business is organized as a corporation or a limited liability company). If you are sued personally, the lender may be able to seize your personal assets to repay the loan. If your business entity is sued, the lender has the right to seize the assets of the company.

Cosigners, Guarantors, and Personal Guarantees

Someone may be required to cosign or guarantee the loan by the lender. If you don't make your payments, the lender will have two individuals to collect from instead of one. If you ask friends or family members to cosign or guarantee a promissory note, be sure they realize that they are putting their own assets at risk if you don't return the debt.

If you've set up your company as a limited liability entity (LLC or corporation), the lender will almost certainly require you, the business owner, to personally guarantee the loan or put your personal assets as collateral. (Lenders are more comfortable if business owners have a personal stake in repaying the money because small firms have such a high failure rate.) Be mindful that personally guaranteeing or cosigning your company's debt voids your limited liability status. If you default on the loan, your individual property, as well as half or all of any property you jointly own with a spouse (depending on which state you live in), might be confiscated.

Finally, if you're married, the lender may want you to cosign the promissory note with your spouse. If your spouse cosigns the loan, not only is your jointly held property at danger, but any assets that your spouse holds independently, such as a house or a bank account, are also at risk. Furthermore, if your spouse works, his or her wages will be garnished if the lender sues and obtains a judgment against both of you.

​​Yoel Molina, Esq. (AKA “Mo”)

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