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March 19, 2018

Banks vs. Private Lenders: The Basics of Financing Options for Small Businesses

By:  Diva Bole, Esquire

Most small business owners will, at some point in the lifespan of their businesses, need to obtain financing in order to get their business off the ground or expand. This article summarizes the basics of obtaining financing through both loans and investors. There are many different options available to get financing for a small business, and what makes the most sense for any one business will depend on a variety of factors.  In determining what makes sense, a small business owner should carefully consider the business’s anticipated needs and get advice from financial advisors, attorneys, accountants, and other experienced industry professionals. 

Financing Through Loans

                In order to obtain a loan from a bank or a private lender, a small business will need to ensure its entity formation is in good order.  This means the entity (usually a limited liability company or a corporation) must be duly formed and in good standing with the State Department of Assessments and Taxation.  The entity should also have bylaws (for corporations) or an operating agreement (for a limited liability company) drafted by an attorney.  The lender will want to review these prior to issuing the loan, and the documents can provide important liability protections for the owner.  The lender will likely require that the owners of the business sign a personal guaranty that guarantees the small business’s obligations under the loan. The main difference between getting a loan from a bank versus a private lender is that the private lender will generally accept riskier loan customers than a bank.  However, the interest rates from private lenders tend to be higher than interest rates from banks.

                Before signing any document with a bank or private lender, a small business owner should seek the advice of an attorney.  It is particularly important to do so before agreeing to a term sheet, because once the term sheet is signed, it is difficult to renegotiate those terms.  In addition to describing the loan and the payment schedule, loan documents contain covenants with respect to the business’s finances, operations, and assets that the small business must follow.  If they fail to do so, such failure can constitute a breach of the loan documents, which would permit the lender to accelerate the maturity of the loan or require a higher interest rate. Typical covenants include financial covenants, which require that the business provide the lender with audited financial statements and maintain certain financial ratios; operating covenants, which require the business to comply with all applicable laws and regulations and prohibit the business from making material changes to the business without the lender’s consent; reporting and disclosure covenants, which require keeping the bank updated; covenants relating to what the business can do with the collateral securing the loan; and cash payout covenants, which govern how the business can distribute out cash.

                Depending on the strength of the small business, an attorney can help seek more favorable terms, such as a requirement that the lender provide the business with notice of a breach of the agreement and an opportunity to cure it prior to seeking the remedies available to the lender under the loan documents.  Attorneys can also try to strike provisions that are particularly onerous to the small business, including, for example, cross-default provisions that would otherwise permit the lender to declare the loan in question in default if the borrower defaults on another debt obligation; or insecurity clauses, which permit the lender to accelerate payment, demand additional collateral, or halt future advances if the lender in good faith thinks the borrower will not be able to repay the debt in accordance with the agreement’s terms.  Even if the attorney is unable to negotiate more favorable terms, he or she can ensure that the small business owner fully understands the loan documents to avoid accidentally triggering a default.

Financing Through Investors

                In some instances, it may make more sense for a small business to seek financing by getting investors to invest cash into the business in exchange for equity in the business.  If done correctly, this will limit the business owner’s personal liability and allow him or her to operate the business without some of the restrictions created by the covenants discussed above.  However, investors into the business will want some degree of control over significant operating decisions. They will also be entitled to distributions and a portion of the proceeds from any sale of the business as long as they own equity in the entity, which can last long after a loan would have been repaid. Furthermore, investors often demand fixed distributions at a preferential rate of return, leaving less cash available to the small business and its owner. 

                There are strict federal and state laws governing the process of obtaining financing through investors.  Small business owners should seek the advice of experienced counsel to ensure they are in full compliance with the law and are not exposing themselves to undue liability.  As a federal matter, generally securities that are sold to the public must be registered with in compliance with federal securities law.  However, there are certain exemptions, including exemptions for private placement offerings to accredited investors (persons or entities that satisfy certain requirements regarding income, net worth, asset size, governance status, or professional experience).  These offerings are conducted through a private placement memorandum and are not offered to the market at large.  Each state also has requirements regarding the registration of securities offerings.  An experienced attorney can help a small business owner ensure that the proper filings are made and that each investor is a duly qualified accredited investor. 

                The small business offering securities must provide potential investors with a private placement memorandum.  This is a document that contains everything the investor needs to know about the business that is necessary to make an informed investment decision.  A private placement memorandum contains information about the business and its financial prospectus, organizational structure, market, and most importantly, potential risks associated with the business. If the business makes a material misstatement in its communications with potential investors or omits information that is material (information that would affect an investor’s decision whether or not to invest), the investor can sue the person offering the securities (the small business owner) personally. A thorough private placement memorandum that describes any and all potential risks of investment reduces the chance that an investor’s claim will succeed. It is important to get the assistance of qualified legal counsel to draft the private placement memorandum to protect the small business owner from potential liability from investors.

 

Diva Bole is an associate in PK Law’s Corporate and Real Estate Group. She focuses her practice area on business formation, mergers and acquisitions, joint ventures, commercial lending, financing and leasing, complex contracts, and corporate restructuring.  Diva can be reached at 410-938-2645 or dbole@pklaw.com.