In a recent post, I encouraged entrepreneurs with secured loans to understand and consider the impact that encumbrances can have on the eventual sale of their businesses. This follow-up post focuses on the front-end implications of debt financing and the entrepreneur's decision (and ability) to obtain a loan in the first place.

It is an old adage that commercial banks will only lend to those who don't need to borrow. Professor Krista Tuomi recently published an article on Angel Capital Association's Blog that seems to reinforce this sentiment in the current climate. In her post, Professor Tuomi considers whether bank loans are still a viable option for start-up companies, emphasizing a need for strong financials and significant collateral before bank financing can be a feasible option for a business. As Professor Tuomi's article explains, lenders view start-up or emerging companies as high risk investments, and the price that entrepreneurs pay for that increased risk (in the form of personal guarantees, burdensome covenants, and aggressive fees, among others) can call into question the feasibility and benefit of debt financing for early-stage companies.

Still, many entrepreneurs view debt financing as an attractive option to raise money while retaining valuable equity and decision-making authority; for others, debt financing is simply the only viable option for capital. Accordingly, we encourage entrepreneurs contemplating debt financing to consider the following five tips:

  1. Ask Family and Friends. Consider whether a family member or friend might be willing to extend the loan instead of a bank or credit union. Obviously, there are non-business concerns to consider and weigh here. However, a family member or friend may be willing to offer more favorable financial terms and covenants, which could benefit the business in the long-run. A convertible note (described below) can be a mutually advantageous way to document a loan from a family member or friend.
  2. Consider a Convertible Note. A convertible note pays interest, but the balance can convert into equity in the company upon the occurrence of certain identified circumstances (usually, an additional round of financing). A convertible note is generally much simpler than a formal bank loan and will typically result in lower legal and administrative fees and expenses for the company.
  3. Consider the Impact on your Personal Credit. Loans to early-stage or emerging companies generally involve a personal guarantee. For this reason, ensure that your personal financial affairs are in order before applying for a loan. Also, consider the impact that a personal guarantee will have on your personal finances (for example, the impact a personal guarantee could have on your ability to obtain a home or car loan).
  4. Get to Know Your Banker. Establish a close relationship with a banker. Although the specific bank is not important, a smaller community bank or credit union may offer greater flexibility to entrepreneurs and emerging companies. Open an account with the bank or credit union and let your banker understand your business goals. Have a strong, well-considered business plan, be professional, and provide thorough and timely responses to your banker's requests. Reinforce that you are someone with whom they want to be in business.
  5. Understand Small Business Administration Loans. U.S. Small Business Association ("SBA") loans offer significant advantages to small and early-stage companies. SBA loans are issued through a participating lender (and not from the SBA directly), so you should ask your banker whether you qualify for any SBA programs that the bank may offer. Familiarize yourself with SBA requirements and the programs that could assist you, and be proactive in seeking them out. Additional information on SBA loans can be found at sba.gov.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.