Is it bad to get a loan to start a business?« Back to Questions List

Is it bad to get a loan to start a business?
Posted by
Asked on March 30, 2017 10:27 pm
1

Thanks for your question.

Generally speaking, businesses should use equity financing (selling stock) to start a business and debt (loans) to scale one. So, without much more information to go by, I’d say getting a loan to start a business is not your best option.

As consumers, we often buy stuff on credit. When we want a new car or a house we get a loan from the bank. When we want a new TV, we charge it to a credit card and make monthly payments. The assumption is that we have sufficient money coming in from a job or other sources that we can use to make the loan payments each month.

However, when we start a new business, especially one from scratch, we often have more expenses in the first few months or even years, then revenue coming in. As a result, entrepreneurs have to continue to feed the business with cash, from other sources, until the business archives what is known as breakeven. Many new businesses may never reach breakeven before their ability to raise more risk capital is exhausted forcing them to shut down operations.

When a business is just starting out it needs to run real lean and curb expenses wherever possible. Debt, in the form of a loan, requires that the business make monthly principle and interest payments, generally from inception, to the lender. This creates a reoccurring monthly expense that new businesses, with limited revenue, can often ill afford to pay.

Early stage equity financing by contrast exchanges a promise by the company to share the business’s profits in exchange for assets, often cash from an investor, that the business will need to reach breakeven. With equity financing, there are no monthly payment that the business must pay to the investor. When the company achieves profitability then the business is often obligated to payout some of the profits to the equity investor(s) based on their share of ownership.

Unfortunately, early stage companies have a high rate of failure. With greater risk comes greater rewards for the risk taker. In equity financing that means the business has to give away more equity, in the form of a lower share price, to the equity investor to provide enough upside incentive to offset the risk. Therefore, you may have to give away a substantial percentage of your business for very little money.

The same is true for debt financing in that the lender will require higher interest rates, larger down payments and shorter terms to offset their risk. This makes the monthly payment on the debt larger, making a cash strapped business even more venerable to depleting all its sources of cash before reaching breakeven.

What I you will discover as you explore the world of debt financing is that lenders will require collateral, and to be more specific, collateral with a reasonably degree of liquidity. What this means is that the lender will loan you money for a tangible asset that they can convert back into cash if you were to stop making payments and they had to foreclose. Moreover, the pledged collateral will need to be highly liquid in that it has to be something that has a ready market to be sold into. A car, truck or home can more easily be sold then perhaps a more specialized piece of equipment like a bottling machine or specialized fixture.

If the funding you seek to start your business is for something intangible, like for working capital, you will likely have to pledge some other form of unencumbered security to secure the loan.

Finally expect to execute a personal guarantee if the debt is in the name of the business. Your business might go away but you will likely out live the business and you will continue to be on the hook to repay the loan.

So, I’d recommend looking for investors first, perhaps in the form of friends or family who will not exact too much equity from you when you are at your most venerable, and look to debt second. If debt is basically your only option, I recommend you read my blog on the Debt Continuum (http://www.stevebizblog.com/the-debt-continuum/) and check out the step by step guide to business loans and financing (https://www.consumeraffairs.com/business-loans-and-financing/) produced by ConsumerAffairs.com to see a list of potential alternative debt funding sources.

Posted by Steven Imke
Answered On March 31, 2017 3:36 pm