To succeed in business, you need money. You need it not only to get started, but also to expand and to ride out periods when your cash flow may be down.
When your own savings are not enough, you must turn to outside sources. These fall into two broad categories: loans and equity investments.
If you get a loan – whether it’s from a bank or a friend – you’re obligated to pay back the money, but you still own the business. If you bring in equity investors, however, you’re taking on co-owners.
Let’s review some legal and practical points for dealing with both sources of funds.
Loans
Loans are simple: 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 repayment is on your shoulders.
If your business fails, you’re on the hook for everything. If your business succeeds and you pay back the lender as promised, you reap all future profits.
In short, if you’re confident about your business prospects and you have the chance to borrow money, a loan is usually more attractive than getting money from equity investors.
Lenders – with the possible exception of friends and relatives – will usually want you to designate some valuable property as collateral. If you don’t keep up with the loan repayment plan, the lender can grab the collateral and sell it to collect what you owe.
A lender, for example, may ask for a lien on the equipment, inventory and accounts receivable of your business. Be aware that a lender isn’t limited to seizing the collateral to satisfy the loan. The lender can also sue you.
What if you lack sufficient assets to pledge as collateral? A lender may ask you to find someone who’s wealthier than you to co-sign or guarantee the loan. That means that if you don’t make your payments, the lender will have two people rather than one to collect from.
If you ask friends or relatives to co-sign or guarantee a promissory note, be sure they understand that they’re risking their personal assets if you don’t repay the loan.
When you borrow, you should sign a written promissory note that states the interest rate and the terms of repayment. For example, a promissory note may require a lump-sum repayment, or it may instead permit you to pay in installments.
Even if a friend or relative is willing to loan you money on a handshake, it’s a poor idea for both of you. It’s better to put the terms of the loan in writing.
Equity investments
Equity investors, unlike lenders, buy a piece of your business. They become co-owners and share in the fortunes and misfortunes of your business. Like you, they can make or lose a bundle. Generally, if your business goes badly or flops, you’re under no obligation to pay them back their money.
Some equity investors, however, would like to have their cake and eat it too. They want you to guarantee some return on their investment – even if the business does poorly. Unless you’re really desperate for the cash, avoid an investor who wants a guarantee.
People who invest in your business may be willing to risk the loss of their entire investment and not insist that you guarantee repayment. But to offset the risk of losing the amount invested, they may want to receive substantial benefits if the business succeeds.
So, an investor may insist on a generous percentage of the business profits. To help ensure that there are such profits, the investors may seek to put a cap on your salary.
Investors may also want to make sure that they won’t become personally liable for business debts. To avoid that exposure, it’s reasonable for them to ask that you structure your business in a way that limits their personal liability. Basically, you can choose one of three formats for your business.
– A corporation offers its owners (shareholders) protection from personal liability for business debts. Generally, creditors can only go after assets owned by the corporation – not by shareholders.
– A limited liability company is similar to a corporation in that the owners – known as “members” – have limited personal liability for business debts.
– A limited partnership consists of at least one general partner, who is personally liable for all debts of the partnership. The limited partners are investors who are not involved in the day-to-day management of the business. The most they can lose is what they’ve invested.
Most small businesses can take on a limited number of investors without having to comply with Federal or state laws that regulate the sale of securities.
