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Types of Debt & Leverage

Types of Debt & Leverage

| March 02, 2020

There are more flavors of leverage than there are ice cream flavors at Baskin Robbins. 

In this post we will address a few of them to help you examine your existing debt structure and to consider other options.

Family Loans

The first and most common kind of debt for new small businesses is family loans. Family loans can be flexible, generous and tax efficient, yet they can be some of the worst for your relationships. Why would you use a family loan versus a bank loan?

When obtaining loans through a financial institution, they will scrutinize your financial situation and will require extensive business and marketing plans as well as a strong credit history. Most banks also require a minimum of two years of operating history. So, new businesses are not usually eligible for bank loans. 

If your credit is relatively poor or if there is a lack of history, getting a loan through a financial institution will be difficult and even if you do get the loan, the terms will often not be favorable. Your interest rates will usually be higher, your length of the loan will often be shorter, and they will likely place a lien on some of your personal property. 

In comparison, family loans are fully negotiable with your family members. You can negotiate both the interest rate and when you start paying principal. Also, you can discuss openly the conditions of what will happen if you do not make a payment for that period. 

Don’t make the mistake of thinking that a loan is free money.

If you accept a “loan” as a gift and do not pay it back, there could be tremendous tax consequences. In 2010, you could accept up to $13,000 tax-free. However, if the “gift” was more than $13,000, you or the giver will need to be ready for a “gift tax” and it could be considered part of your income.

If the IRS does an audit of your taxes (which business owners tend to be subject to more than individuals due to their complicated returns), this could turn out to be a particularly nasty tax headache. 

Make sure to treat the loan as a loan – you need to pay back the loan with interest and principal overtime. Borrowing money from an older, wealthier generation can be a terrifically tax-efficient way to allow younger family members to increase their wealth. 

On the other hand, a family loan may not be right for you. Take some time to consider your relationships. We have seen many clients who have borrowed from a family member that we call a “suck.” This individual will hold the loan over your head and may hold you emotionally or mentally captive. 

For example, they may give you grief over not doing things their way or coming to see them over the holidays and then whine about how they loaned you money and that you “owe” them for the loan. Talk carefully with your significant other about whether a family member is a suitable candidate for a family loan. How do they react to financial issues? Is this somebody with whom you would want a business relationship? Are they flexible and fair? Would this loan possibly destroy your relationship if you could not pay it back? Do they have the financial resources to withstand losing the loan? 

Bank Loans

There are several criteria you must meet to take advantage of bank loans.

First, you need to have a strong credit history. The banks dig up your credit reports and find your bad debts, so make sure you are aware of any skeletons in your closet.

Second, make sure you have a strong relationship with your bank. This means you will need at least several years of personal and corporate banking experiences. 

If your business qualifies for a loan, banks will have many types of debt to offer.

For example, there are lines of credit which you can increase and decrease depending upon your cash needs. The benefit of these lines of credit is that they can sit unused for an indefinite time. It benefits the business owner because the loan is available if you want it. So, if times get tough, you have a cushion. You will not have a time frame of when the principal will need to be paid back.

The interest rate charged will usually fluctuate up and down with the federal funds rate and the prime rate. Usually, the bank charges the prime rate plus an interest rate of one or two percent. Be wary of rising interest rates as well as your bank’s overall rating on you and your company. 

Imagine having a $200,000 loan. Your interest payments could be 3% today. This is close to $6,000 in interest annually or $500/month. If the loan's interest rate climbs up to 10%, this would increase your interest costs annually to $20,000! This is a difference of nearly $1,200/month! How drastically would this change your company's cash flow and its future? 

You have to keep an eye on the financial health of your company. Unsuspecting customers can suddenly have unused credit lines yanked out from underneath them or reduced substantially if their FICO score deteriorates. 

On the other hand, banks will also offer you fixed traditional loans where you pay interest and principal. These sorts of loans are usually determined by their underwriters at a regional or corporate headquarters. 

In order to keep informed about the bank and your situation, you will also want to form a close relationship with your business banker. Take them out to lunch and tell them about the plans for your business. Get to know them and their family as well as their bank and their position at the bank. Find out who the key decision makers are and who might approve your future loans. 

We encourage you to show your business banker a highly detailed business plan and have them meet your board of directors, if possible. There may be a time when you need to ask a favor, and you will want to make sure to have put “deposits” into your business banker’s emotional account. 

Even after you have accomplished these tasks, the banker still has to meet various loan criteria. They do have some leeway, but there are some mountains that cannot be moved. Banks are looking for a certain amount of history and revenues. 

They will usually ask for your personal and business balance sheets as well as previous years’ tax returns and a solid business plan. If you have a new business or a relatively young business, they will typically ask for the owner to guarantee the loan by putting up collateral – for example a lien on your personal property, most likely your home. If you are already highly levered and you do not have a strong business history, there is a high likelihood you will not get a loan or the interest rate will be sky high. 

Small Business Administration (SBA) Loans

Another common form of leverage is government subsidized loans – particularly the Small Business Administration. In 1953, the SBA formed as a federal government agency to assist in the development, growth, and counseling of small businesses. 

According to the SBA’s website, it has delivered about 20 million loans and other forms of assistance to small businesses. From 1991 to 2000, it helped nearly half a million small businesses get $94.6 billion in loans. In 2007, SBA backed more than $12.3 billion in loans. 

These loans are primarily designed for small businesses who could not otherwise obtain financing from banks, family, or other sources. Please note that the SBA is primarily a guarantor of loans made by private and other institutions and does not offer loans to small businesses. 

Essentially, the government backs the loans. It is remarkably similar to FDIC insurance at a bank. If the loan sours and the borrower defaults, they pay the money back to the bank for the risk they took up to a certain amount. 

The 7(a) program is their most popular program – with billions of dollars going into them each year. All 7(a) loans must meet 7(a) criteria. The business gets a loan from its lender with a 7(a) structure and the lender gets an SBA guarantee on a portion of this loan (for example 75 percent to 90 percent of the loan is guaranteed). That’s why the primary business loan assistance program available to small businesses from the SBA is the 7(a) guarantee loan program. 

A key concept of the 7(a) guarantee loan program is that the loan comes from a commercial lender, not the government. If the lender is not willing to provide the loan, even if they may be able to get an SBA guarantee, the SBA cannot force the lender to change their mind. 

There are several kinds of businesses who cannot receive SBA loans. These include real estate investment firms, investment firms that specialize in speculation through futures or collectibles or commodities, lending firms, pyramid sales plans, and gambling companies. 

The maximum loan available through the 7(a) guarantee loan program is $2 million, but this is relatively uncommon. Their most common programs include the Patriot Express and the Community Express. Both of these have relatively lower limits at $500,000 and $250,000, respectively. The Patriot Express will guarantee a maximum of up to 85 percent of the loan while the Community Express will follow the 75 percent to 90 percent guidelines. 

The interest rates you can be charged varies depending upon the program and the borrower institution. Interest rates may be fixed or variable. Fixed rate loans of $50,000 or more must not exceed the prime rate plus 2.25 percent if the maturity is less than seven years. Loans in lower amounts will have even a higher interest rate spread. 

SBA loans also have distinctive loans for female, minority or military veteran business owners. They have specific rules that apply to those loans, often offering you lower interest rates and better terms. 

Your banker should be familiar with SBA loans, so make sure to ask them about them. However, keep in mind that the bank ultimately has to approve the loan. They are not obligated to give out the loan. They are the ones who are on the hook (or partially anyhow) and accountable to the SBA.

We have covered just a few types of debt and leverage. Stay tuned for next week’s post where we continue our discussion and provide a few more options you can consider!

Material discussed is meant to provide general information and it is not to be construed as specific investment, tax, or legal advice. Individual needs vary & require consideration of your unique objectives & financial situation. Please consult with your accountant or tax advisor for specific guidance.