When an entrepreneur or business person seeks to start a business, they often seek out a business loan in order to help manage business startup and operating expenses. Taking out a business loan may also be referred to as debt financing.
The reason behind a business loan is simple: typically, business owners and entrepreneurs cannot afford to self-fund their business from its start. Business loans are becoming more popular and commonplace, due to more entrepreneurs and business people seeking to start their own businesses.
It is important to note that business loans differ vastly from receiving financing through investors. When financing a business through investors, also referred to as financing through equity investments, the business owner makes no guarantee that they will fully repay the investors. Instead, the investors purchase a piece of the business and take a risk on the business to succeed. Then, if the business does succeed, that investor will be repaid on their investment through profit sharing and dividends.
As can be seen, financing a business through business loans is vastly different than financing a business through equity investments. The main advantage in utilizing business loans instead of investors is that the business owner gets to maintain complete control and ownership of the business. On the other hand, the main advantage of financing through equity investments is that the business owner does not have to pay back the loan.
There are also disadvantages for both business loans and financing through equity investments. As noted above, if a business owner takes out a business loan they are on the hook to pay back the loan in full, as well as any interest that accrues. For example, if a business person takes out a business loan of $750,000 for startup costs and operating costs, they will only be able to keep the leftover profits after paying back their loan installment.
Conversely, if a business person choose to finance through equity investments, then they will have to share a portion of their profits for so long as that investor holds a share of their company. In addition, the business owner will have to consult that shareholder and tailor their policies and practices to their expectations. Thus, business loans allow a business owner the freedom to operate their business how they see fit, as well as the ability to keep any profits left after any loan payment.
As mentioned above, if you choose to finance your business through equity investments, you are in essence selling a piece of your company to the investor. Typically, investors take a passive role in their investment, as often they do not wish to take on active roles in the daily management and operation of a business. In such cases, an investor is merely seeking to invest in the company in hopes for a good return on their investment as the company grows.
However, financing a business through equity investments will drastically change the structure of the business. First, the business owner will be held accountable by the shareholders of the company. Further, should the business owner or entrepreneur lose their majority interest in their company by not maintaining more than 50% stake, they will likely lose a great amount of autonomy and management rights.
Additionally, shareholders and investors typically will also seek to limit their liability. This means that although investors are willing to risk the money they invested in the business voluntarily, they are not willing to lose more than their initial investment through future business debts and lawsuits.
There are three common business structures that protect investors from being liable for company debts and lawsuits:
- Corporations: By creating a corporation, you are essentially creating a legal entity distinct from the corporation’s owners. Generally, corporations allow shareholders to be free from any liabilities of the business, such as business debts or lawsuits. However, organizing a corporation is expensive, and the corporation must follow strict guidelines as to its organization and operation. Additionally, corporations are subject to double taxation;
- Limited Partnerships (“LPs”): Limited partnerships consists of one or more limited partners and one or more general partners. In a limited partnership, the general partner is in charge of the day to day operations, whereas the limited partner merely acts as an investor. However, in limited partnerships, the general partner remains liable for all of the partnership’s debts and lawsuits. Additionally, the limited partner may also be liable if they manage the business or otherwise act as a general partner; and
- Limited Liability Companies (“LLCs”): Similar to a corporation, an LLC also offers limited liability to its shareholders. Further, LLCs are less strict as to their daily management. However, with less structure as to how the company is operated and less protection for investors, investors are more wary of investing in an LLC.
In short, assurances are essentially promises. Before lending a business owner money, the lender will typically require multiple assurances be given by the person or entity seeking the loan. For example, if their credit history or current assets are questionable, the business owner may need to have a cosigner or guarantor sign the business loan as well. As a cosigner or guarantor, that person would become personally liable for the loan repayments should the business fail, or the business owner become unable to pay for the loan.
In addition to asking for a cosigner some other assurance a lender may seek include:
- Asking for collateral;
- Asking for additional information on the business, including a business plan document, business financial statements, etc.;
- Asking for insurance information; or
- Asking for a loan covenants, which are essentially conditions that a borrower must fulfill or refrain from doing.
As can be seen, choosing whether or not to take out business loans or financing through equity investments can be a complex decision. Typically, business owners will seek a combination of both debt financing and equity financing. However, finding the correct balance of debt financing and equity financing is difficult as the laws regarding the loan process and business formation vary from state to state.
Therefore, if you are an entrepreneur or business owner considering seeking a business loan, it is in your best interests to consult with a well qualified and knowledgeable business attorney. An experienced business attorney can help inform you of your state’s laws regarding the loan process, as well as guide you throughout the process. Additionally, they can help you draft any necessary legal documents, and represent you in a court of law, if necessary.