Raising Money for your business
Oct 1, 1997 12:00 PM,
Fred S. Steingold
To succeed in business, you need money not only to get started, but also toexpand and to ride out occasional periods when your cash flow may be down.
When your own savings are not enough, you must turn to outside sources,which fall into two very different categories: loans and equity investments.
If you get a loan from a bank or a friend, you’re obligated to pay back themoney, but you still own the business. But if you get money from equityinvestors, you’re taking on co-owners.
Let’s review some legal and practical points for dealing with both sourcesof funds.
LoansLoans have the virtue of simplicity: someone gives you money, and youpromise to pay it back, usually with interest. Because you must pay backthe lender whether your business is a fabulous success or a miserablefailure, the entire risk of your enterprise is on your shoulders.
If your business fails, you’re on the hook for everything. But if yourbusiness succeeds, and you pay back the lender as promised, you reap allfuture profits.
In short, if you’re confident about your business prospects, and you havethe chance to borrow money, a loan is usually more attractive than gettingmoney from equity investors.
Lenders — with the possible exception of friends and relatives — willusually want you to designate some valuable property as collateral (alsocalled security). If you don’t keep up with the loan repayment plan, thelender can grab the collateral and sell it to collect what you owe.
A lender may want a second mortgage on your home or may ask for a securityinterest in your mutual funds or the equipment, inventory or accountsreceivable of your business. Be aware that a lender isn’t limited toseizing the collateral to satisfy the loan. The lender can also sue you.
What if you lack sufficient assets to pledge as security for a loan? Alender may ask you to get someone who’s wealthier than you to co-sign orguarantee the loan. That means that if you don’t make your payments, thelender 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 youdon’t repay it.
When you borrow, you should sign a written promissory note — an IOU thatsays, in effect, “I promise to pay you $X plus interest of Y%,” anddescribes how and when payments are to be made.
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 a better business practice to putthe terms of the loan, including the interest rate and repayment plan, inwriting.
Sign only the original of the promissory note. When it’s paid off, you’reentitled to get it back. Keep a photocopy of the signed note — marked COPY– for your records.
Equity investmentsEquity investors, unlike lenders, buy a piece of your business. They becomeco-owners and share in the fortunes and misfortunes of your business; likeyou, they can make or lose a bundle. Generally, if your business goes badlyor flops, you’re under no obligation to pay them back their money.
Some equity investors, however, would like to have their cake and eat ittoo. They want you to guarantee some return on their investment, even ifthe 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 face the loss of theirentire investment and not insist that you guarantee repayment. But tooffset the risk of losing the amount invested, they may want to receivesubstantial benefits if the business succeeds.
For example, an investor may insist on a generous percentage of thebusiness profits and, to help ensure that there are such profits, may seekto put a cap on your salary. The terms are always negotiable.
Investors may also want to make sure that they won’t become personallyliable for business debts. To avoid that exposure, it’s reasonable for themto ask that you structure your business in a way that limits their personalliability. Basically, you can choose one of three formats for your business.
A corporation offers its owners (shareholders) protection from personalliability for business debts. Creditors can only go after assets owned bythe corporation, not by the shareholders.
A limited partnership consists of at least one general partner who ispersonally liable for all debts of the partnership. The limited partnersare investors who are not involved in the day-to-day management of thebusiness. The most they can lose is what they’ve invested.
A limited liability company is a relatively new business entity, which isnow approved in all but a few states. All owners have limited personalliability for business debts.
If you operate your business as a corporation or limited partnership, youmust comply with federal and state securities regulations. The law treatscorporate shares and limited partnership interests as securities. In somecases, a limited liability company may also come under these laws. Thismeans that before taking money from investors, you’ll need to learn moreabout the requirements of securities laws. Fortunately, generous exemptionsallow most small businesses — and some mid-sized businesses — to take ona limited number of investors without complicated paperwork.