This article considers the legal basics of getting a small business loan. For this discussion, it will be assumed that the loan is to either start a new business or to buy an existing one. A business loan should also be distinguished from a "line of credit" or an "overdraft", which are generally used to address liquidity issues for an existing business.
While matters such as the loan interest rate, size of the principal and term are essentially commercial questions for the borrower, a small business loan will almost always be more attractive to a lender if it is secured in some way. Accordingly, legal advice is of great assistance to understanding your loan and security obligations.
It is likely that your bank or lending institution will view a business loan used to fund a new business as a somewhat risky venture. Although you may have banked as a consumer with the lender for some period of time, financing a new business creates the possibility that the borrower may be unable to repay the loan (known as "defaulting"). As the probability of the lender being repaid is directly linked to the success (or failure) of the business, you should expect the lender to be very interested in how well you have planned your business and what you will do to cover the possibility that the business may have difficulty repaying. Most business loan applications require detailed information on the business' marketing, expected growth, operating plans and your previous experience in the commercial world.
It is therefore important to have considered many basic questions regarding business structuring before applying for finance. As the business operates in a separate way to your ordinary finances, many new business owners choose to establish a company to trade through. This is not essential, but does (at the very least) help to reinforce the separate legal status of the business. A lawyer will also be able to advise on other alternative structures (such as a partnership or corporate trust). This is not to say that operating as a sole trader is undesirable in the lender's view, but it is important to demonstrate that you have considered how the business will be constituted.
Security for the Loan
"Security" refers to assets (or monies) that the lender can use to secure the borrower's obligations under the loan. Again, the form of security the lender may require can vary depending on the business' structure, but may include:
- For a sole trader, requiring the borrower to mortgage an existing asset (such as the family home); or
- For a company, giving the lender a bill of sale or a fixed and/or floating charge over the company's assets (together with personal guarantees given by the company director(s)).
It is vital to get a solid legal understanding of exactly what security interest the lender is acquiring under the loan. For example, a fixed charge may permit the lender to sell a particular asset if the borrower defaults on the loan (even if the sale of that asset would prove disastrous for the business). Alternatively, if the business mainly has trading stock (such as goods or supplies), a floating charge may achieve the same result.
Once the lender has approved the loan, it will draw up documentation consisting of:
- The loan schedule (or terms sheet), which will outline the commercial details of the loan (such as the interest rate, term and key dates);
- The lender's standard terms and conditions (which will likely not be negotiable when dealing with a large lending institution); and
- Any relevant security the lender is taking, together with legal documentation necessary to give effect to the security.
Although the success of the business is up to you, it pays to be careful when considering a business loan. Having a lawyer's advice to understand your loan obligations gives you one less thing to worry about, instead letting you focus on getting your business going. Additionally, a lender will typically require a borrower to show that it has obtained independent legal advice if a guarantee is involved (as guarantors have been able to avoid their obligations by demonstrating that they did not understand what they were agreeing to).