Debt: The sequel
OK, so last time we covered why businesses may use debt – and for what purpose. So far, so good. But we didn’t talk about anything practical. Let’s deal with that. Starting with:
Where do I get the money from?
Well, that will depend on your circumstances. If you’re starting out, you really have two options:
- Commercial lenders – typically banks and credit unions.
- So-called “love money” – otherwise known as friends and family.
There are a few other options. Credit cards are always an option, but definitely not your first one, as they are a very expensive way of getting your hands on money.
I’m wary of so-called “angel investors”. The name is misleading…. in most cases, the people who have money earned it by hard commercial sense – which includes how they negotiate deals. As angel investors are taking a significant risk, they’ll likely also want a piece of your business up front – or the option to buy it at a low price, if it takes off. Nothing angelic about them, believe me! On the other hand…. if you can accept their price, and the relationship starts and remains good, their input and experience can be very useful. If you want a mentor, of course.
Finally, there are also specialist lenders: leasing companies (who will help you acquire equipment) and factoring companies (who will advance you cash against the security of your trade receivables). Each has their place. If you’re a young entrepreneur, there are special funds out there for you too.
A shout-out to BDC, as well – they’re a Crown Corp, whose mandate is to support entrepreneurs. Good for equipment and property. I won’t say they’re less commercial than the high-street banks, but they can sometimes open more doors.
On the high street
We all know how banks work. They take in money from savers, and lend it out to borrowers. They make their money by charging more in interest (and fees) than they pay out. They lose money if they lend money and can’t get it back. At its simplest, that’s all you need to know. Although my banking friends will go to great lengths to explain how they differ from each other… we’re just tinkering around the edge.
My top 10 tips:
- A new business is a risky start-up. Unless the business has significant assets it can pledge as security – or you are able to guarantee it – the business won’t be able to borrow “real” money until it has a couple of years behind it.
- You will need a plausible business plan, with assumptions that are as detailed and supported as possible. (Actually, this is a good idea anyway.) Be sensible in these assumptions. Any business plan I’ve ever read has conservative assumptions, according to their authors.
- Arranging a loan takes longer than you think. Always. Period. Plus, the experience can be very frustrating…if your loan has to go up the food chain for approval, you can expect requests for new information at each stage.
- The main banks are comparable. But, as in any business, the individuals vary. A good banker will make the application process as painless as possible and look after you throughout.
- Read the whole agreement. Yes, really. It will have things that surprise you. In particular, there may be covenants – which are essentially where you promise not to do certain things (eg. spend money, take money out, visit the washroom) without permission.
- If you’re buying equipment, you will have to pay the HST on it and claim it back later (see earlier post “HST101”) – which affects your cashflow. The loan will NOT cover the HST. You’ll have to fund that yourself.
- Budget for fees as well as interest. And you may have to factor in the cost of a more expensive year-end process. Often, a bank will ask you to upgrade your year-end financials to a “review” engagement. This means that your accountant has to spend more time on the year-end, giving the bank a signoff saying the numbers are plausible. It’s more invasive than financials prepared just for taxes. It adds no value to your business other than helping you keep the loan.
- Negotiating a loan is like any other negotiation. The more leverage you have, the more you can refine the terms. But lenders have some lines they can’t cross (some of which are regulated). It helps to understand what those are.
- Don’t despair if you fail to meet the requirements once or twice. Clearly, it’s best to honour your commitments, and increases the odds of being able to borrow again later. But… bankers don’t like to call in their loans. It’s an admission of a bad lending decision – and normally the last resort, as it reduces the risk the bank gets anything back.
- Bank managers are nice people. Remember their birthdays. Take them Timmies when you visit. And never give them nasty surprises.
Keeping it at home
Having read of all the above, you might decide – or realize you have no choice – to call on your family and friends for funding, rather than go to a commercial lender. After all, who has a more vested interest in your success than your loved ones?
This is an entirely legitimate source of funds, although probably better suited to a fixed loan than a more flexible overdraft. However, my advice here (to both sides of the transaction) is simple:
Behave exactly as if you were borrowing from a bank.
Why would you do this? Well, people may do things for their family without necessarily thinking it through. So, if Mom guarantees a $100,000 loan for your new business, there is a risk that she may be called on to honour it. (That’s why the bank asked). So, pay her a guarantee fee. It’s a nice way to acknowledge what she has done for you – and the act of paying it will hopefully clarify to all that she is taking on some risk for that fee. *
Also, please put any such agreements in writing. You don’t always need to lawyer it up, but at least make sure you have covered the amount, what interest (if any), what security you’ve offered (if any) – and a repayment schedule. Do your utmost to keep to that schedule. It’s the right thing to do, and will minimize conflict.
Do you really need to do this? Well, yes. I’ve seen what happens if you don’t. There are always pressing needs on your business cash, and if making that payment to Uncle Bill is not something you have scheduled in, somehow it just never happens. Then…. Every time you see each other, he will drop hints that he’d appreciate a repayment. Then… if you haven’t repaid him, clearly you’re not running your business well – so he may start to offer unsolicited advice. Let’s just say that can add an interesting wrinkle to family reunions. Particularly if his spouse or kids get involved.
Keep it clean and simple, and all will be well. I promise.
*Footnote: Any interest or fees you pay to family members for a business loan are deductible for tax purposes. Of course, your lender is equally required to declare the income on their side. But that’s their issue – not yours.