As you know, a loan is based on a simple idea: someone gives you money and you promise to pay it back, usually with interest. Loans are so common that you probably are familiar with the mechanics, but nevertheless it makes sense to review the basics. The success or failure of your business can hinge on borrowing money sensibly: you want to borrow enough that your company can reach its potential but not so much that you have severe difficulty paying it back.
Start on a shoestring. It can be a mistake to pour too much money into your business at the beginning. A fair number of small businesses fail in the first year, so raising and spending a pile of money for an untested business idea can lead to much grief -- especially if you're personally on the hook for borrowed funds. Consider starting as small and cheaply as possible.
Types of Lenders
You have many options when looking a loan for your business. For small ventures, friends and family members are sometimes willing to help. For sophisticated or mid-sized businesses, banks, credit unions, and savings and loans may be willing to lend you money. For tips on obtaining a loan from such an institutional lender, see Small Business Loans: Getting the Lender's Approval. The U.S. Small Business Administration (SBA) and many state and local governments have loan programs to encourage the growth of small businesses. For an excellent primer on loans and lenders, see www.sba.gov/financialassistance.
The Promissory Note
A lender will almost always want you to sign a written promissory note -- a paper that says, in effect, "I promise to pay you $XXX plus interest of XX%."
While a friend or relative may be willing to lend you money on a handshake, this is a bad idea for both of you. It's always a better business practice to put the loan in writing, and to state a specific interest rate and repayment plan. Otherwise, you open the door to unfortunate misunderstandings that can chill your relationship. Also, you want to have documentation of the loan's terms in case the IRS decides to audit your business.
To learn about different repayment options and promissory note terms, read Understanding Promissory Notes for Small Businesses.
State usury laws prevent lenders from charging illegally high interest on loans. As a general rule, a lender can safely charge you interest of up to 10% per year and not have to worry about violating this usury law. However, there's a lot of variation in usury laws from state to state, and different rules apply to commercial lenders and private lenders, so you should check your state's law if you're concerned. Look under interest or usury in your state's statutes.
If your corporation is taking a loan from a shareholder (including yourself), make sure the interest rate is not too low -- the IRS likes to see loans that are commercially reasonable. Otherwise, the IRS might consider the loan as a capital investment by the shareholder and treat the loan repayments as dividend payments to the shareholder.
Many lenders will require you to put up valuable property (called "security" or "collateral") that they can sell to collect their money if you don't make your loan payments. For example, a lender may take a second mortgage or deed of trust on your house, or ask for a security interest or lien on your business's equipment, inventory, or accounts receivable.
Depending on how your business is organized, if you don't make good on your repayment commitment, a lender has the right to sue you individually (if your business is a sole proprietorship or general partnership) or sue your business entity (if your business is organized as a corporation or a limited liability company). If the lender sues you individually, it can take your personal assets to satisfy the loan. If the lender sues your business entity, it can take the business's assets.
Cosigners, Guarantors, and Personal Guarantees
A lender may also require that someone cosign or guarantee the loan. That means the lender will have two people rather than one to collect from if you don't make your payments. When asking friends or relatives to cosign or guarantee a promissory note, be sure they understand that they're risking their personal assets if you don't repay the loan.
If you've organized your business as a limited liability entity, such as a corporation or an LLC, the lender will probably ask you -- the business owner -- to personally guarantee the loan and/or pledge your personal assets to guarantee repayment. (Because small businesses have high failure rates, lenders feel more comfortable if business owners have a personal stake in repaying the money.) Be aware that guaranteeing or personally cosigning your business's loan circumvents your limited liability status. All of your separate property, and either half or all of any property you jointly own with a spouse (depending on which state you live in), could eventually be seized if you default on the loan.
Finally, if you're married, the lender may insist that your spouse cosign the promissory note. If your spouse cosigns the loan, not only is your jointly owned property completely at risk for this joint debt, but also any assets that your spouse owns separately -- a house, for example, or a bank account. What's more, if your spouse has a job, his or her earnings will be subject to garnishment if the lender sues and gets a judgment against the two of you.
For all the legal and practical information you need to get your business off the ground and running, get Legal Guide for Starting & Runing a Small Business, by Fred Steingold (Nolo).