Borrowing Money
Funding the initial start-up of your business can be difficult. You have just started your business and you immediately begin incurring debts with cash that you do not have. I remember when we started our law firm all we had was an overdraft and a credit card. We decided that we did not want to borrow a lot of money to start the business (otherwise we would just be paying a lot of our future profits to the bank), so we never touched the overdraft and established an internal line of credit with our own money.
However, depending on the type of business that you are starting, obtaining finance may sometimes be a necessary step to ensure that you can operate your business through the phases of the Business Legal Lifecycle. If you are starting a business that has large upfront capital costs such as a food supply business, a stationery business or a glass supplier, for example, you will need to spend money to buy your products before you start to sell them to your customers.
How to finance your business
There are a number of options available to business owners to access funding to pay for the upfront start-up costs of their business, including:
- (a) Lending your own funds to the business
- (b) Borrowing money from a bank
- (c) Borrowing money from friends or family
- (d) Debtor finance
- (e) Equipment finance
Lending your own funds to the business
Using your own funds to start your business is obviously a risky proposition; however, if you have the cash, it may be your best option. In choosing this option you don’t need to worry about how you are going to pay yourself or your debts, and you will be able to generate a realistic projection of those costs against your income. Ideally, you should prepare a cash flow projection, a full year budget and business plan before you start. Again, at this stage, it is imperative that you obtain advice from key consultants such as accountants and financial planners.
You may not be aware of all of the costs that are involved in setting up a business so it is vital that you properly plan your startup funding arrangements (if you haven’t already done so in the Conception phase).
Borrowing money from the bank for your business
If you don’t have the cash to fund your own start-up costs, then you need to consider other funding alternatives. Borrowing from a bank is one of the most common methods to fund a start-up business. I am certainly not against banks and, indeed, believe that they are an essential player in setting up and funding your business.
However, I have seen business owners work hard to build strong relationships with particular bank managers, only for those bank managers to move on and leave the business owners to deal with a new bank manager and rebuild the relationship from scratch. Or, worse still, because the bank has all of their assets tied up, they use this transition to become stricter in their lending conditions as the personal relationship no longer exists.
From the Case Files
This is exactly the situation that confronted one of our clients with large property holdings. The client had a business in investing and developing large commercial and industrial properties. He owned properties that were valued at over $60 million and was in debt to one bank that had funded him for over 20 years for approximately one third of the value of his properties. When he became embroiled in a dispute with his business partner, and despite the fact that the properties had significant equity, the bank stepped in and prevented my client from exercising his control over his assets without any reason other than the fact that there was a dispute and the bank did not want it to affect the value of the properties it held as security. This caused my client to enter into a protracted legal battle that cost both sides close to a million dollars in legal fees. Another one of our clients is also a property developer with significant equity in a number of properties. The properties range from residential to commercial and industrial and the client had, over a 10-year period, built a strong portfolio of property assets with significant equity and a very good rental return. The client also had a long-standing relationship with his bank and one bank manager in particular. Just before the beginning of the 2008 global financial crisis (GFC), the client entered into a contract to sell one of his properties. Before entering into the contract, the bank manager told him that he could take 50% out of the sale proceeds to fund another project because the bank had sufficient equity in the other properties. At this time the bank manager suddenly left to pursue a different career. The new bank manager told the client that, as a result of the GFC, the bank tightened their lending criteria and changed their mind, taking all of the funds from the sale. The consequence of this was that the client was forced to secure additional startup funding through the bank at a higher rate and at a significantly higher cost in fees and lost opportunities. In a situation where the client was hoping to free himself from the constraints of the bank, a change of relationship manager and policy meant that he was even more closely controlled by the bank. Had he been able to secure startup funding from a different bank, the client would have been able to negotiate a much better deal.
Banks love to take security over a number of assets (cross collateralisation) especially when you’re first starting your business. For example, if you own a house, the bank will most likely require security over the house so that if you default in the repayments, it can sell your home to repay the debt, as really there is no value in selling the struggling business. This represents a considerable risk, especially if you own the house with a spouse or partner because the bank may require a personal guarantee from that person as well.
This should be avoided if possible as, more often than not, your spouse or partner will not be involved in the business and they risk losing their home as a result of the business going bad. If your bank says ‘no’, keep looking because you will probably be able to find another five banks that will say ‘yes’.
In my experience there are two main strategies when borrowing from banks:
- (a) Build relationships with a number of banks and play them off against each other to obtain the most favourable terms, although this can still have negative consequences if one of the bank managers leaves.
- (b) Engage an experienced and competent mortgage broker who can liaise with different banks and get the best deal on your behalf. Additionally, it is important to also liaise with an accountant and financial planner so that your consultants know what is going on and can give you the best advice.
Borrowing money from friends or family
Borrowing money from family and friends must be seen as the last resort. When borrowing money from a bank, there is always the risk of the bank stepping in and taking control of the business if things turn sour. If you borrow money from someone you know, be prepared that they are likely to want some involvement in your business. You might be shocked to find that you gained a ‘de-facto partner’ instead of a lender.
Of course people never enter into the transaction with any malice, but unfortunately things can and do go wrong, not only damaging the business but also the relationship with the family member or friend. If you decide to borrow money from someone you know, it’s imperative that the agreement is properly documented and clear ground rules are established to regulate the lender’s role (if any) in the business so that the relationship is well-managed. Both parties need to understand that they are entering into a serious business transaction; to run the business properly rules are necessary and will be strictly enforced.
From the Case Files
I saw this type of relationship turn sour a few years ago when a business owner came to see me as he had lent money to his son-in-law to start a business. The father-in law was an elderly gentleman who had worked for a salary all his life and he had built up a strong savings portfolio. He wasn’t, however, aware of what was required to run a business so when his son-in-law approached him to help with a new business venture, he happily agreed. However, there was no agreement or understanding between them as to what the terms of the lending arrangement were or the level of involvement that the father-in-law had in the business. The father-in law was concerned that his son inlaw was ‘out socialising’ instead of working to build the business. He felt that his son-in-law was simply wasting his money and wanted to get his money back. After many discussions he approached his son in-law accusing him of taking his money and not taking the business seriously. On a positive note, it turned out that the son-in-law had simply been networking and was genuinely trying to build up his business, and that the father in-law had misunderstood what was going on. Unfortunately, the mistrust caused massive divisions within the family that took years to resolve. Admittedly, this was an extreme case, but it is a real life illustration of how mixing business with family can lead to severe consequences. On the other hand, I have also seen success stories where this kind of relationship has worked. A client of ours, who had recently retired after 40 years of operating his own business, sought our advice when the person he sold the business to wanted to borrow money from him. The business was a road transport one that had significant overheads in the trucks and machinery used in the business. The new owner had attempted to expand the business into other areas and they had not been successful so he was struggling from an operating cash flow perspective. The new business owner had a house that was virtually unencumbered that they could provide as security for the start up business loan. After many discussions, the client took a commercial stance, engaging independent valuers to value the house and allowing us to properly document the loan. The documentation clearly set out the rights and obligations of the parties and there was a clear understanding between the old business owner and the new one that the relationship was limited to that of a lender/borrower relationship and the old business owner was to have no involvement in the business. By dealing with each other professionally and at an arm’s length, the transaction proceeded without a hitch and the relationship remains strong.
Borrowing money from family and friends can be risky but with the right advice and proper establishment, it can work.
Debtor finance
Debtor finance, also called ‘debt factoring’ or ‘invoice lending’, is where you accept a percentage payment from a debt factoring company on the value of the invoices you have issued to your customers or clients. The debt factoring company then assumes the responsibility to chase payment of the full amount of the invoice and they pocket the difference. For certain types of businesses that require immediate cash flow to buy stock (e.g. a printing business) this type of finance can be of great assistance, especially in the short-term start-up phase before cash flow is enough to maintain liquidity.
There are a number of issues that can arise with debtor finance:
- You ‘lose’ a significant amount of your profit
- Usually if the debt is not paid within a set timeframe, for example 60 days, you are required to pay the money back to the debt factoring company that has provided it to you. You do not get any of your interest or other cash back and you lose that money
- Your ability to borrow from other lenders may be affected as your book debts will not be available as security for other borrowing options
- Customers may not like dealing with a third party on the payment of their debts
If you opt to use this type of finance, you should ensure that it is a short-term fix to your operating cash flow problems as it will seriously impact upon your profits. Again, it is imperative that you obtain the right advice from your lawyer, accountant, financial planner and/or mortgage broker to ensure that all of your circumstances are considered and that it is the right funding option for you.
Equipment finance
Another common funding avenue for business owners is equipment finance, which is commonly used when a business needs a piece of equipment or a vehicle. There are many different options and you need to ensure that you get the best deal for your business in terms of start-up cash flow and value for money. Your accountant, financial planner and mortgage broker will assist here in getting you the best deal. Beware of the latest deal from a financier or a vehicle dealer, which will usually result in you paying the full price for the vehicle (or piece of equipment) as well as paying interest on the loan.
From the Case Files
A client of ours had a business that had two different premises. It was an accounting firm that had two owners who visited both offices on a regular basis as they had significant clients at both office locations. The different premises were more than 50 kilometres apart. This meant that the business owners needed a number of vehicles to travel between the two business premises. The client used the services of a broker on the basis that the purchase price was being paid upfront. This meant that the client, when negotiating the purchase price of the vehicles, was able to receive the lowest available market price and interest rate for the vehicle. This differs to the situation where you might take finance directly from the vehicle company, who will usually have a competitive interest rate but you will end up paying a higher price for the vehicle
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