Friday, December 08, 2006

The Lowdown on Business Loans

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.)

Repayment Plans:
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.

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