Many entrepreneurs look to family and friends for loans, especially when they are starting up their company because it’s tough (although not impossible) to borrow money from a bank or credit union to start a business. Ignoring the personal relationships involved, personal loans are viable options not to be overlooked. They often carry lower interest rates and generally have a less formal approval process than those from standard financial institutions. There are a few IRS rules to watch out for, though, and there are about a thousand reasons to have a legally-binding written loan agreement signed, so consult with your attorney or tax advisor before Aunt Sadie reaches into her cookie jar.
For larger or longer loans-or if you want to avoid the psychological quagmire of borrowing money from your brother-in-law-you’ll want to turn to the people whose purpose in life is lending money: banks, credit unions, and savings & loans. The thought of going through the loan application and approval process can be very off-putting, but it’s kind of like spinach; you may not like it but you’re a better person for eating it. The process of compiling the necessary information and thinking through your proposal will help you focus on some important shop management factors.
It may not seem like it, but banks are actually eager to loan you money because that’s where they make their profits. These institutions will grant your loan if you can show that your business proposal is sound. They will turn your loan down, however, if they judge you to be a bad credit risk. While your personal credit history may be a factor in the decision, most of the time bank loans are denied because the proposal was inadequate or poorly presented. Your shop’s financial history alone is generally not sufficient proof that the loan you’re requesting is secure. For that, you need to show that the future of the business is rosy enough to make the probability of repayment very high.
Don’t even think about applying for a loan unless you know exactly how much money you need, what you need it for, and how you will pay it back. Every one of those items will need to be substantiated in some way, too. How much money you need is directly related to the amount of cash your shop generates now, so you’ll obviously need up-to-date financial statements (backed up by a CPA’s analysis and/or tax returns). What you need it for comes from your marketing plan and answers questions like who is going to buy the product you are going to make and the likelihood of their purchase based on competition, pricing, the economy, past purchases, etc. The question of how you will pay it back is answered by your cash flow projections.
Assuming your proposal answers all the pertinent questions, your financial institution is probably still going to ask for some sort of collateral and/or a personal guarantee. The collateral, of course, may include the assets (equipment and inventory) of your business, real estate, marketable securities, or other tangibles the financial institution can sell if they have to. They probably won’t consider as collateral the value of your company as a going concern-because they don’t want to operate it, which is what the bank would have to do if they took over your business in the event of a failure.
The personal guarantee is slightly different. A lien against your home, bank account, or other personal assets assures the bank not so much that they can recoup their money in the event of a failure, but that you have a strong incentive to keep running your shop and living up to the terms of the loan. They know it’s much easier for the borrower to walk away and leave the bank holding his unsold inventory than it is to give up his car.