By far, borrowing is the most used source of external capital for small companies, accounting for something like 90% of capital raised. Despite the prevalence of borrowing, finding a lender is not an easy job. Small companies can spend 600 man hours or more searching for a willing lender.

The process of looking for a lender is really a process of educating potential lenders about one=s business. Banker education is a never ending process even in the unlikely event that a company is permitted to stay with the same bank.

The reputed benefit of borrowing is that the entrepreneur gets to use the money and also keeps control of his company. The truth is that things aren't as straight forward as that. Most of the time, creditors will want collateral for the loan. Collateral is something of greater value than the amount of the loan which the lender can sell if the debtor fails to repay the loan. Although you owe the collateral, you can=t sell it until the loan is paid off and/or the collateral is released by the lender.

Lenders may impose a number of other conditions, sometimes called covenants, on the borrower.

The lender may ask the borrower to keep specific balances in certain accounts. If he fails to do so, the loan may be called, which could force the borrower to sell part or all of his company.

In some cases, the lender require that all payments for goods sold be made to him. The lender will take what is owed him and send the rest to the borrower. Depending on the speed at which the lender sends your money to you, this can be a real problem. It is hard to get employees to understand that their payroll checks bounced because the bank was slow in turning over the receivables. It has happened.

There goes the entrepreneur=s control.

Most entrepreneurs start out borrowing from friends and family, either because they know that no bank will touch them, or because the terms and conditions of the loan are better than the bank would make, or because the entrepreneur feels more comfortable asking friends and family for money than he would parading his ignorance of how banks work. More companies come undone because the owner didn't think he knew enough to run a company and didn=t want anyone else to find out than any other reason. Conversely, companies don=t really take hold until the owner is ready to admit that there may be things that he doesn't know about running a business. The truth is that nobody is born knowing how to run a business. We all have to learn. The smart ones learn by asking.

In this section we will discuss the fundamentals of borrowing money, first from friends and family and then from lending institutions.

Put It in Writing

Whether you borrow money from a bank or someone you know, you should make sure each party, you as the borrower, and the lender understand exactly how things are going to play out. This protects you as well as the lender. For instances, some people think that lending their child, or their friend money entitles them to run the company. Make sure the loan document spells out how the lender can make sure his loan is safe. For instance, he may get periodic financial statements. He may not start ordering the workforce around and he certainly may not appropriate company property. On the other side, you agree to pay a specified amount of interest at specified times and you agree to repay the principal is a specified manner.

The simplest and most widely used loan document is a promissory note--a legally binding contract in which you promise to repay the money. Most promissory notes say, in effect, "I promise to pay you Ax dollars ( the amount borrowed), plus interest of some %." The note then goes to describe how and when the payments are to be made. Any arrangement both parties freely agree to are generally acceptable, but typical terms require even payments of interest and principal over the life of the loan (as in a mortgage or a car payment plan) Other arrangements may say that only the interest needs to be paid for some period, and the principal and interest payments are to be made. In real estate, the balloon payment is popular. This permits the borrower to use his money and the borrowed money to create value. When the value is realized, say at the sale of the property, the lender gets his principal and all owed interest.

Key Issues When You Borrow

Whenever you consider borrowing money, you'll want to keep these key issues in mind:

Why do you want the money?
What do you expect the project to return?

That will tell you what interest you can afford to pay.

If the project, and money should be borrowed for specific projects with a foreseeable payout, seems worthwhile the terms of the loan that you should pay strict attention to include:

The rate of interest you'll pay.
The structure of the borrowing entity

If your business is a corporation or limited liability company (LLC), will the owners (corporate shareholders or LLC members) personally guarantee the loan? In in very unlikely event that they don't, they have no personal legal obligation to repay if the business collapses.

What will be your personal liability

Partners and sole proprietors are always individually liable to repay money they borrow.

Will you put up your house or other property as security for the loan? Commercial lenders are far more likely to require this than are family members and other personal lenders.

Taking the time to draft a well-thought-out promissory note can help preserve friendships and family harmony. It's smart to sign a promissory note even if the friend or relative from whom you're borrowing assures you that such formality isn't necessary. Think of it this way: documenting the loan can do no harm--and it can head off misunderstandings about whether the money is a loan or gift, when it is to be repaid and how much interest is owed.

Banks provide their own promissory note forms, but if you borrow from a friend or relative, you'll need to come up with one on your own. Their legal and practical terms can vary considerably. How do you pick the form that's right for you, and that won't cause your business unexpected trouble down the road? Here are four different approaches.

Promissory Note--Equal Monthly Payments

If you've ever taken out a mortgage or car loan, you're familiar with this arrangement. The note requires you to pay the same amount each month for a specified number of months. Part of each payment goes toward interest and the rest goes toward principal. When you make the last payment, the loan and interest are fully paid. In legal and accounting jargon, this type of loan is said to be "fully amortized" over the period that the payments are made.

Once you know the amount you want to borrow, the interest rate and the number of years over which you'll make payments, you can figure out the amount of the payments using software such as Quicken or Microsoft Excel. Or you can use a printed amortization schedule; these are widely available from commercial lenders, business publishers and local libraries.

Sample Promissory Note in equal payments

1. Promise to Pay. For value received, ___ , (Borrower) promises to pay _______,Lender) $a certain amount and interest at the yearly rate of some % on the unpaid balance as specified below.

2. Monthly Installments. Borrower will pay _____(so many) monthly installments of $____(so much) each.

3. Date of Installment Payments. Borrower will make an installment payment on the____ (specific day) of each month beginning at _____(a specific date) until the principal and interest have been paid in full.

4. Application of Payments. Payments will be applied first to interest and then to principal.

5. Prepayment. Borrower may prepay all or any part of the principal without penalty.

6. Loan Acceleration. If Borrower is more than __30__ days late in making any payment, Lender may declare that the entire balance of unpaid principal is due immediately, together with the interest that has accrued.

7. Security

This is an unsecured note.
Borrower agrees that until the principal and interest owed under this promissory note are paid in full, this note will be secured by a security agreement and Uniform Commercial Code Financing statement giving Lender a security interest in the equipment, fixtures, inventory and accounts receivable of the business known as ____.
Borrower agrees that until the principal and interest owed under this promissory note are paid in full, this note will be secured by the mortgage deed of trust covering the real estate commonly known as _________________ and more fully described as follows:

____________________________________________________

8. Collection Costs. If Lender prevails in a lawsuit to collect on this note, Borrower will pay Lender's costs and lawyer's fees in an amount the court finds to be reasonable.

Dated: ____

Name of Business:____, a ____(type of business)

By:____(signed) Printed Name: ____

Title: ____

Address: ___

____

Promissory Note--Equal Monthly Payments and a Final Balloon Payment

This type of note used to be very popular in the red hot Texas real estate market. It is best used as project finance when, a payout is expected at the end of the project. A loan to buy materials to build a house is a good example, provided there is reason to believe that the house will be sold at a known price when it is completed. This note requires you to make equal monthly payments of principal and interest for a relatively short period of time. Then, after you make the last installment payment, you must pay the balance in one payment, called a balloon payment. This type of promissory note offers definite benefits to you. Because of the lower monthly payments during the course of the loan, you can keep more cash available for other needs. Of course, when you're thinking about those nice low payments, don't forget the big balloon payment waiting around the corner.

The obvious advantages of this arrangement are the low initial payments. If you find yourself in the happy situation of having extra cash, you can prepay principal. But over the long term, you'll pay more interest because you're borrowing the principal for a longer time. On a $20,000 loan at 7%,to be paid back in four years, you would pay nearly $3,000 less by making equal amortized payments than if you made interest-only payments plus a final balloon payment.

Promissory Note--Single Payment of Principal and Interest

If your lender agrees, you can promise to pay off the loan all at once, at a specified date. This payment includes the entire principal amount and the accrued interest. Borrowing money on these terms is best for a short-term loan, or if the lender isn't worried about on-time repayment.

The $20,000 four year loan at 7% would require a payment of $25,600 at the end of the loan period. Earlier payment would reduce the cost.

Stewart-Gordon Associates, Inc.
P.O. Box 781992
Dallas TX 75378-1992
voice (972) 620-2489
fax (972) 406-0213
e-mail Tom Stewart-Gordon