Borrowing For Start-Up Can Pay Off

Selling stock is one way to raise capital for a new venture, but it’s not the only attractive alternative.

Q. Some time ago you described how an entrepreneur could secure funding through the sale of common stock. Since my company’s shares are probably worth much less today than they will be five years from now when my business is really established, I’d rather borrow the money I need to get started.

A. Borrowing can be a sound course of action, if you can find accommodating lenders, if your firm’s cash flow is sufficient to pay a reasonable rate of interest, and if you are willing to provide the follow-on “hand-holding” that will be required.

A start-up is typically an “iffy” proposition and funds-providers generally want to be adequately rewarded for the risk they take. As a consequence, most look for more than just a market rate of interest and a promise that they’ll get their money back someday. For them, the possibility of losing everything can be offset only by an opportunity to hit it big if you are successful. That means holding shares that can appreciate.

Notwithstanding such understandable investor self-interest, many venturers do succeed in borrowing money. However, most of it comes from their charge cards and a second mortgage on the family homestead. The rest generally comes from family members who want to help.

Friends and family members are probably the most likely sources of borrowed funds at this stage of your operation. But going into hock with those close to you can create some unique headaches.

First of all there is the issue of “closeness.” They will always be there to watch and give “friendly” advice. You’ve got to deal constructively with such kibitzing since they will be major stakeholders in your operation. Often their uninformed advice will be at odds with what you, the hands-on CEO, know to be best. Consequently, there can be some uncomfortable family picnics and Christmas dinners.

Also, give some thought to the family fractures that could occur if your business takes a terminal tumble. Ouch. (In my experience, people seem to take more kindly to losing their investment in stock than they do to getting stiffed on a loan, although either alternative is likely to create long-lasting, hard feelings.)

Remember, too, that unless your loan provides a rate of interest that is considerably above prevailing market rates - reflecting the risk of your venture - their funds are as much a gift as they are a loan. As a result, these kinds of funds-providers require a special kind of time-consuming TLC.

Your No. 1 job with respect to family creditors is communication. Keep them well-informed and insulated from surprises. Devise a system of reports or periodic meetings where they will all get the same information and each will have an opportunity to vent. If they feel like they are part of the action, they will also implicitly assume responsibility for what happens, good or bad. A well-structured communication program will also allow you to conserve time, energy and expense.

Secondly, there is the issue of “formality of arrangement.” Make sure the entire loan transaction is properly documented. Such care will help obviate nasty disagreements with creditors and the IRS in the future. Even if the generous family member is willing to go on a “handshake,” you still have the IRS.

If ol’ uncle Ollie gives you more than $10,000 and there is no supporting loan documentation, the IRS will probably look at it as a gift and levy a gift tax on the provider. Further, if the business goes bust without an adequate paper trail for lenders, they will have a difficult time writing off their losses.

If possible, structure the transaction as a business loan rather than a personal loan in case misfortune requires the loan to be written off. A formal loan agreement is essential and it should reflect the date of the loan, the amount, repayment terms, the date the loan will be paid in full, and the interest rate that will be paid.

In most circumstances, a “no interest loan” is a “no-no.” The IRS can “impute” interest on such arrangements, meaning that, while the lender is not actually receiving interest from you, the IRS will tax him as if he had.

xxxx