If you are talking about friends and family type of capital investment, there are some considerations that you want to give to this transaction that go beyond just business considerations. Usually there’s a personal relationship that is very important to all of the parties to preserve, and it’s important when you are creating those kinds of relationships, that you have very full and frank discussion of what the possibilities are, what the expectations are, so that everybody comes into the deal with their eyes wide open. Makes everything so much easier if all of those possibilities are discussed in a full and frank manner at the outset.
Usually it does a lot of good to get some consultation on those kinds of arrangements with a professional, trusted advisor, like a lawyer. Other people can probably give you valuable input on that as well, other business people. CPA’s have valuable insight on those sorts of issues. What you need is to get a sense of what’s reasonable, what’s realistic, what’s common in this sort of arrangement in terms of what’s a fair agreement as to compensation, return on investment, control of the company by the investor, control of the company by the person that’s going to be running the business.
All of those issues can get pretty sophisticated. They need to be considered at the outset, and it’s a lot easier if you consider those issues at the outset rather than once a problem arrives.
A due-on-sale clause is an agreement that usually exists in loan documents where the borrower is representing to the lender that they are going to be using the building or the real estate, whatever kind it is, for certain some purpose, and they are personally going to be using it.
They get the loan and that is one of the representations that the lender is relying on: how are you going to be using this property? Because they want to be make sure that they property is protected and used in the appropriate way, and that it’s value is being preserved. One way they so that is through this kind of a term, a due-on-sale clause.
The due-on-sale clause says if you sell this property, that is secure our loan, we can call your loan due. We can accelerate the due date on your loan and require it all to be paid when you sell. This may be the case even though you may be perfectly willing to continue to make the payments. Even though the deed of trust that the lender may have on the property is still valid and enforceable. The lender still has that provision in the loan document that says, no we can call the loan due if you sell the property.
Occasionally, lenders will use that term for some negotiating leverage where they don’t have any objection to allowing you to sell the property, or allowing the new person to take over the loan, but, they’ve got the power to extract something out of you, so sometimes they will. Say okay, we’re going to waive our due-on-sale clause here, but it’s going to cost you $5,000. Lenders can do that sometimes.
There is a statute in Arizona that calls into question the enforceability of due-on-sale clauses. There’s also some case law in Arizona that calls into question the enforceability of due-on-sale clauses. You’re going to want to look at those before you make any decisions based on some expectations you have of how the law is going to apply to your situation. It may not be as it seems in the loan documents.
Another thing you need to be aware of when it comes to due-on-sale clauses is what constitutes a sale, because sometimes you can trigger a due-on-sale clause unintentional. For instance, an individual may own property in their own name, maybe it’s a husband and wife that owns property in their own name, and then they convey that property into a living trust that’s going to benefit their family. Is that a transfer? Is that a sale? Does that trigger the due-on-sale clause? Well, it may, it may not, but it’s something that you may want to consider before you make a move on that.
Also, you may have an individual, or a husband and wife that own property personally, and they decide hey, this really ought to be owned by the business, it’s our business that’s owning this property. Let’s convey it into the name of our business. You have a similar situation there. The use of the property may not have changed but the actual ownership of the property has changed and there is a risk that you have triggered a due-on-sale clause in that instance. It’s something that you want to be aware of so you can make the best decision possible.
The third way of capitalizing your business and this is the optimum way, this is ideally the way that your business will operate in normal circumstances, and that is to plow back earnings into the business. You want your business to be generating enough cash to cover expenses and you want your business to generate enough cash to pay its’ owners as well. I mean, that’s the reason why the owners invested in this business.
You also want your business to grow, and you want that growth to be funded by the earnings of that business. What you really ought to do is make a plan for a portion of your earnings to be plowed back into the business. That is the safest way to grow a business.
You’re not incurring additional debts to creditors. You’re not bringing in additional investors. Every investor is going to have its’ own agenda for things that it wants to see in the business, and sometimes investors can actually bring in a really valuable insight to a business and sometimes it’s highly desirable to have that. But other times you don’t want more voices in the board room who are advocating for a certain position, so you don’t want to have to bring in additional people and the best way to do that is to plow back some retained earnings back into the business to grow it.
The first category for capitalizing your business is investment, and that investment can come either from you or from some third party. That is known as equity. The person who invests money into a company receives ownership in the company.
The second way of capitalizing your business is by having the business borrow the money. Now, the business can borrow money from an institution, like a bank, or it can borrow money from smaller financial institutions or private equity lenders. It can also borrow money from the principals of the business, you.
The third category for capitalizing a business is plowing back retained earnings into the business.
There are also non-institutional lenders from whom you can borrow. In general, the cost of that money that you would be borrowing from the non-institutional lenders is going to be significantly more expensive. In other words, you’re going to be usually paying higher interest rates, higher loan fees. Sometimes that’s worth it. Sometimes you need the capital and it makes sense to incur those additional financing costs to get the capital.
This does certainly force you to consider the question, should I really be borrowing this money? Why am I borrowing the money? This is true whether we’re talking about an institutional investor, where the financing comes relatively inexpensively, or a non-institutional lender, where it may be very expensive money. In either case, there is a cost associated with borrowing that money, and you need to really look at that cost before you jump into it.
It’s easy to get into a mentality of feeling a desperate need for cash and wanting to satisfy that need, come what may, because, “Man, I got to make payable right now.” That’s a feeling that business owners can identify with. While I appreciate the urgency that exists sometimes, it also needs to be a measured and reasonable decision that you’re making to borrow money. You need to look at the costs of borrowing. The costs of borrowing are not strictly financial. There is actually quite a psychological toll that borrowing can put on you, because you now have this obligation, this creditor, who is expecting repayment. Something you need to think about, and it makes sense to discuss that with your trusted advisers.
One type of loan that you may qualify for through an institutional lender is an SBA loan. Institutional lenders will also do non-SBA loans, but usually the terms of those loans are not quite as favorable as the SBA loan. The reason they’re not as favorable usually is that the lender is taking more risk. They don’t have the guarantee of the SBA. That’s something that should be explored. Normally when lenders are lending money to a business, they are wanting to secure that loan against collateral. Oftentimes that will be real estate.
For instance, let’s say that you have a design firm. You want a building to constitute to your office space, but also to be a show piece. You want this to really be a beautiful office that you’re going to do business in. Those offices can be very expensive especially if you’re going to finish them out with all of the finer details. That kind of a business owner is going to encounter the question of, “Do I want to buy this building? It would be nice to own my building if I’m going to put all of this into it. Or do I want to lease it?” You may be able to buy that building, even though you may not have anywhere near the cash you need to take down the purchase of that building.
A bank may be willing to finance that purchase by taking the building as collateral or as security for their loan. Normally in those kinds of loans the banks are also looking to secure the loan with basically everything the business has. They’ll take a lean on the building, and they’ll also take a lean on the receivables of the business, and they’ll also take a lean on the equipment that the business owns and every category of property that you can imagine, they’ll want a lean on. They want to get paid if you don’t pay according to the terms of your loan agreement with them.
One of the important things to do in an investment relationship is to get it started the right way. I already talked about the importance of having a full and frank discussion with all of the parties that are going to be involved. What are the expectations? What are the potential problems? What are we going to do if these kinds of problems arise?
I would actually suggest before you have that conversation, even though it needs to be right up near the beginning of your to-do list, even before that you need to talk to a trusted advisor about what are some of the specific issues that you ought to be discussing with your friends or family so that you can have a full and frank discussion.
I have found that one of the real barriers for people in getting going in their business is they don’t know what to do to get started. They have this idea for their business and they may have way more than an idea. They may have some processes in place. They may have a tremendous amount of skill. They may have sales that are ready to go. They may have a lot of things in place, but they really don’t know how to approach the investors that they’re going to need to get the business off the ground. That will actually just kill some deals. Many, many deals stay right there in that stage, the idea stage.
It’s helpful to go and talk to an attorney and explain what your idea is, what you’re trying to accomplish, what you think some of your potential investment capital sources are, how you are going to approach those sources, what are the things you need to discuss with them, what is your agreement going to look like.
It makes all the difference in the world when you’re going to speak to an investment capital prospect as to whether you’re prepared, whether you have your ducks in a row, so to speak. If you show up for the meeting with the big investor and all you’ve got is an idea and no structure, it’s not going to be a very attractive investment opportunity for that investor usually.
If, on the other hand, you have a plan that you’re ready to execute, that includes an operating agreement for your LLC, something that’s going to provide for your investor to get a return of their capital, maybe on a preferred basis to money that you would be receiving from your business. If you’ve thought those kinds of things out, that eliminates a lot of the noise in the investor’s head which will contribute to concern in the investor’s mind.
There’s just a huge benefit to having worked through those kinds of details right at the very beginning of your investment capital raising efforts.
So when you’re looking at institutional lenders for your business, there’s a couple of different kinds of loans that you may be able to obtain. Probably the one that applies most often would be an SBA loan. SBA stands for Small Business Administration.
There are a lot of banks that have a niche market in SBA lending. They target small businesses as their customers and they will extend these loans to them through the SBA program. This SBA program is very helpful to small businesses in obtaining credit because what happens in that loan is the Small Business Administration basically guarantees a portion of the loan. The bank’s risk in lending capital to your business is reduced because if you go belly-up, they’re not at a complete loss. The SBA is going to step up and pay a portion of that loss that the bank has as a guarantor.
It dramatically reduces the bank’s risk in lending to small businesses if they’re able to make the loans through the SBA program. There are certain guidelines that you have to qualify for or fit within in order to receive SBA financing. And that is a subject that we could speak on at great length. Suffice it to say, it’s an issue that you wan to advise your counsel or get the advice of your counsel on. And it’s also something that you can discuss with your banker.
I find it’s very helpful to have a relationship, and I know how this stuff works, and so they can help you set your business up so that you will qualify for this type of a loan program.