Borrowing Money for Your Business
If you run a small business — or would like to start one — you’ll probably need to raise money at one time or another. You may want to expand on your success, or you may suddenly need extra cash in an emergency. No matter what the reason, if you need to tap outside sources for cash, you essentially have two choices: borrow money or sell an ownership or equity stake in your business. Here we focus on raising money by borrowing, which has the big advantage of keeping business ownership in your hands. Most entrepreneurs borrow money privately from friends or family members, or apply for a loan from a bank or other institution. Some do both.
Key Issues When You Borrow
Whenever you borrow money, you’ll want to keep these key issues in mind:
- The rate of interest you’ll pay.
- If your business is a corporation or limited liability company (LLC), will the owners (corporate shareholders or LLC members) personally guarantee the loan? If they don’t, they have no personal legal obligation to repay if the business collapses. Partners and sole proprietors are always individually liable to repay money they borrow.
- Will you put up your house or other property as security for the loan? Commercial lenders are far more likely to require this than are family members and other personal lenders.
Putting It in Writing
Whether you borrow money from a bank or someone you know, you should sign a promissory note — a legally binding contract in which you promise to repay the money. Most promissory notes say, in effect, “I promise to pay you $_____, plus interest of ___%” and then describe how and when you’re to make payments.
Taking the time to draft a well-thought-out promissory note can help preserve friendships and family harmony. It’s smart to sign a promissory note even if the friend or relative from whom you’re borrowing assures you that such formality isn’t necessary. Think of it this way: documenting the loan can do no harm — and it can head off misunderstandings about whether the money is a loan or gift, when it is to be repaid and how much interest is owed.
Banks provide their own promissory note forms, but if you borrow from a friend or relative, you’ll need to come up with one on your own. Their legal and practical terms can vary considerably. How do you pick the form that’s right for you that won’t cause your business unexpected trouble down the road? Here are four different approaches.
Promissory Note — Equal Monthly Payments
If you’ve ever taken out a mortgage or car loan, you’re familiar with this arrangement. The note requires you to pay the same amount each month for a specified number of months. Part of each payment goes toward interest and the rest goes toward principal. When you make the last payment, the loan and interest are fully paid. In legal and accounting jargon, this type of loan is said to be “fully amortized” over the period that the payments are made.
Once you know the amount you want to borrow, the interest rate and the number of years over which you’ll make payments, you can figure out the amount of the payments using software such as Quicken or Microsoft Excel; or you can use a printed amortization schedule. These are widely available from commercial lenders, business publishers and local libraries.
Promissory Note — Equal Monthly Payments and a Final Balloon Payment
This note requires you to make equal monthly payments of principal and interest for a relatively short period of time. After you make the last installment payment, you must pay the balance in one payment, called a balloon payment.
This type of promissory note offers definite benefits to you. Because of the lower monthly payments during the course of the loan, you can keep more cash available for other needs. Of course, when you’re thinking about those nice low payments, don’t forget the big balloon payment waiting around the corner.
Promissory Note — Interest-Only Payments and a Final Balloon Payment
With this type of note, you repay the lender by making regular payments of interest. The principal stays the same. At the end of the loan term, you must make a balloon payment to cover all the principal and any remaining interest.
The obvious advantages of this arrangement are the low initial payments. If you find yourself in the happy situation of having extra cash, you can prepay principal. But over the long term, you’ll pay more interest because you’re borrowing the principal for a longer time. On a $20,000 loan, paid back in four years, you would pay nearly $3,000 less by making equal amortized payments than if you made interest-only payments plus a final balloon payment.
Promissory Note — Single Payment of Principal and Interest
If your lender agrees, you can promise to pay off the loan all at once at a specified date. This payment includes the entire principal amount and the accrued interest. Borrowing money on these terms is best for a short-term loan or if the lender isn’t worried about on-time repayment.