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Securing a Loan for Your Small Business: A Guide

Small business loans are similar to personal loans, with a few minor differences. 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'll find information on how to time a small business loan and promissory notes and cosigners. To learn more, visit FindLaw's Starting a Business section.

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When To Use Small Business Loans

Many startup owners make the mistake of taking out too many loans too quickly for a new business. Before locking yourself into a loan amount, explore other means of structuring your business or securing financing.

Minimize the number of loans you take out. Your business plan should focus on a timeline of your business's cash flow and customer base. Once established, consider opening a business line of credit or apply for a U.S. Small Business Administration loan (SBA). Suppose payments on the loan start coming due before the business begins producing sufficient revenue to cover them. In that case, it can put serious pressure on the business's cash flow.

Before you start signing loan documents, consider a few alternatives:

  • Operate on a shoestring: Many businesses can initially run on a shoestring budget. It may not sound glamorous, but consider whether you can run your business from a garage, spare room, or 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 doesn't have to be paid back—it's essentially an investment like any other. The obvious catch with selling a portion of your company for cash is that you'll lose some control and forfeit some of your profits down the road.
  • Talk to family and friends: Friends and family might be able to support your business idea. While still technically loans, you can generally get much more favorable terms from friends and family than from a financial institution. Even if their loans are small, enough small loans from friends and family can really help make a difference, especially in the beginning.

Make sure you adequately document loans from friends and family to ensure clarity and understanding down the road.

Where To Get a Loan

Your personal and business credit scores determine where you can apply for a loan. Lower interest rates are available to businesses with high creditworthiness or that provide a downpayment.

Commercial loans are different for borrowers than personal loans. Of course, all 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 financing options include:

Government entities like the Small Business Association (SBA) may be able to offer you loans as well. The SBA loan programs provide small business owners loans when they can't secure loans from a traditional bank. SBA loan programs require SBA lenders to enact eligibility requirements, such as:

  • Inability to secure financing from a financial institution
  • Bad credit or a minimum credit score
  • Minimal working capital

Many states and larger cities also have local organizations designed to stimulate business investment. These small business financing programs can be found through your local chamber of commerce or Small Business Development Centers. These specialized business organizations often offer discounted loan rates due to government subsidizing.

Documents Needed for Small Business Financing

Entrepreneurs will need the following when applying for small business loans:

  • Average annual revenue
  • Bank statements from your bank account (if open)
  • Credit history
  • Personal financial statements
  • Personal guarantee if you are a sole proprietor or solo member LLC
  • Tax returns (personal and business)

Your specific business needs or background may require you to provide more information. But if you have good credit, you may not need to provide as much information. The information you need to provide is on the business loan application.

The Promissory Note

Once you've decided who your lender will be—even if it's a business credit card—the basic financial instrument behind most loans is a promissory note. As its name suggests, it's a document in which you promise to pay back a certain amount of money (the principal). You agree to repayment terms at a certain interest rate over a period. You repay the loan in installments.

If your funding option is to borrow from friends and family, don't just shake a hand or verbally promise to repay the money. As a business owner, you should know how important it is to get things in writing. Setting the loan terms in writing helps clear up any potential misunderstandings. It can prevent the destruction of a meaningful relationship.

It's equally important to have it in writing if you get audited by the Internal Revenue Service (IRS) at some point. Without an agreement, money from friends and family may seem more like a gift to the IRS. Even if your friends and family tell you they don't need you to write it, explain to them that it's important for financial record-keeping and to protect you from the IRS.

Interest Rates

Always shop around for the best rate—higher interest rates can impair a business's ability to keep current on its loans. Consider what you can consistently repay even in months when your accounts receivable is low.

In addition to finding the best rate possible, business owners should monitor two other aspects of interest rates.

First, interest rates on bank loans that are too high may violate state usury laws limiting the maximum interest rates allowed. Usury laws vary from state to state, so check your state's laws. Ensure you're not taking out an illegal loan if the interest rate seems quite high.

Second, although low interest rates sound great, be careful. The IRS may view a loan with a really low interest rate as a capital investment rather than a loan. This would have serious tax and ownership consequences for your business.

Collateral and 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 even if you have excellent credit. In that case, you may have to put up personal collateral. This could be 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, they should already be aware of the risks. If you're going to have friends or family cosign the loan, make it very clear exactly what the risks are:

  • Spouses: Some lenders require the spouse to 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 ensure they are comfortable with that possibility.
  • Limited liability companiesLimited liability companies generally shield business owners from personal liability. But if you or other business owners cosign the loan, you're stepping outside of the protection of a limited liability company. Your jointly held and separate property could be seized to satisfy the debt.

Small Business Loan Legal Help

Having the right legal information about a small business loan is important. If you are starting a business, consult an experienced business law attorney to understand financing risks and avoid costly mistakes.

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