Getting a Loan for a Small Business
Created by FindLaw's team of legal writers and editors | Last reviewed September 21, 2022
Business loans are fundamentally pretty similar to personal loans with a few small caveats. How a business structures its debt and manages its cash flow can be the difference between a successful business and one that ultimately fails.
Below you will find information on timing of a small business loan to promissory notes and co-signers. To learn more, visit FindLaw's Starting a Business section.
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When to Use Loans
Many new business owners make the mistake of taking out too many loans too quickly instead of exploring other means of structuring their business or securing financing. While loans can be used at any point during a business's life, it's always better if you can minimize the amount of loans you have to take out until your business's cash flow and customer base is well established. If payments on the loan start coming due before the business begins producing sufficient revenue to cover them, it can put serious pressure on the business' cash flow.
Before you start signing loan documents, consider a few alternatives:
- Operate on a shoestring: Many businesses could be run on a shoestring budget in the beginning if they really wanted to. It may not sound glamorous, but consider whether you can run your business from a garage, spare room or almost entirely online.
- Consider selling equity: The other primary method of financing a business is to sell an equity stake in the company for a sum of money. That money does not have to be paid back and is essentially an investment like any other. The obvious catch with selling a portion of your company for cash is that you will lose some control as well as forfeit some of your profits down the road.
- Talk to family and friends: You'd be surprised how willing friends and family might be to support you. While still technically loans, you can generally get much more favorable terms from friends and family than you can from a financial institution. Even if their loans are small, enough small loans from friends and family can really help make the difference, especially in the beginning. Make sure you adequately document loans from friends and family to avoid any confusion and misunderstandings with them down the road.
Where to Get a Loan
Commercial loans are a little different than personal loans in terms of where you can get them. Of course all of the same financial institutions that would give you a personal loan will probably be able to help you with a business loan as well. These include banks, credit unions, and savings and loans.
In addition to the usual suspects, government entities like the Small Business Association (SBA) may be able to offer you loans as well. Many states and larger cities also have local organizations that are designed to stimulate business investment, so before you run to the nearest bank, check to see what other options may be available to you. These specialized business organizations can often offer discounted rates on loans because they are subsidized by governments and other organizations.
The Promissory Note
Once you've decided who your lender will be, the basic financial instrument behind most loans is the promissory note. As its name suggests, it is a document in which you promise to pay back a certain amount of money, the principal, at a certain interest rate over a set period of time.
If you elect to borrow money from friends and family, don't just shake a hand or verbally promise to repay the money. As a business owner, you should be extremely aware of how important it is to get things in writing. Setting the terms of the loan in writing helps clear up any potential misunderstandings down the road and can prevent the destruction of an important relationship.
It's equally important to have it in writing in case you get audited by the Internal Revenue Service (IRS) at some point. Money from friends and family without an agreement may seem more like a gift to the IRS. Even if your friends and family tell you they don't need you to put it in writing, explain to them that it's important for financial record-keeping and to protect you from the IRS.
Always shop around to get the best rate because higher interest rates can really impair a business's ability to keep current on its loans. In addition to finding the best rate possible, there are two other aspects of interest rates to watch as a business owner.
First, interest rates that are too high may violate state usury laws that limit the maximum interest rates allowed. Usury laws vary greatly from state to state, so check your state's laws to make sure that you're not taking out an illegal loan if the interest rate seems quite high.
Second, although really low interest rates sound great, be careful. The IRS may view a loan with a really low interest rate as a capital investment into the company rather than a loan, which would have serious tax and ownership consequences for your business.
Collateral & Personal Liability
Many lenders will require that you put up some sort of collateral for the loan. As a business owner, you may be able to use business assets as collateral (such as office equipment and property).
Chances are good, however, that your business assets won't cover the loan. In that case, you may have to put up personal collateral, such as taking out a second mortgage or deed of trust on your house. Depending on how you've set up your business, the lender may also be able to sue you personally and take your personal assets to satisfy the loan.
Cosigners and Guarantors
A lender may require a cosigner or guarantor on the loan. If you have a business partner cosign the loan, he or she should already be aware of the risks, but if you are going to have friends or family cosign the loan, make it very clear exactly what the risks are:
- Spouses: If you are married, there's a good chance that a lender may require that your spouse cosign the loan. Make sure you and your spouse understand that it's not just your jointly owned property that may be at risk. Your spouse's separate property can also be reached to satisfy the debt, so be very clear with your spouse and make sure that he or she is really comfortable with that possibility.
- Limited Liability Companies: Although limited liability companies generally shield business owners from personal liability, if your or other business owners cosign the loan, you are effectively stepping outside of the protection of a limited liability company. All of your jointly held and separate property could be seized to satisfy the debt.
Business Loan Legal Help
Having the right legal information about a business loan is imperative. If you are starting a business, consult an experienced business law attorney now to better understand the law and avoid costly mistakes in the future.
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