Many of my clients are business owners of varying sizes. Regardless of size, the common denominator in my experience is cash flow issues regardless of being a start-up company or a company that is looking to expand. When it comes to raising money for a business start-up or expansion, business owners often ask if it’s better to use debt or equity financing. In some cases, it may be better for the business owner to use public debt sources (banks), before going to private equity sources such as venture capital firms and private equity groups. Using private sources will usually cause the equity ownership of founders and early investors to be greatly diluted.
First, it is typical and logical for a bank to want to protect its investment. If the owner dies prior to repayment of the loan and the business fails, the bank has no easy means of collecting. A simple, straightforward method of guaranteeing repayment is through life insurance.
During the business loan application process, the banker will encourage the business owner to either utilize an existing life insurance policy or purchase a new one in the amount of the loan, and for at least the period of the loan. For example, if the bank is making a loan for $500,000 to be paid back over 10 years, the policy proceeds would have to cover that specific amount and time.
The owner may not want to reallocate personal insurance away from his family to satisfy this business need, since they would presumably need the cash if income from the business was no longer available upon the owner’s death. Therefore, it is most common for business owners to acquire a new life insurance policy, which will be payable to the lender by a “Collateral Assignment.” This document entitles the lender to their amount at risk from the loan.
As the balance of the loan is repaid during the owner’s lifetime, the lender’s claim to the death benefit decreases. Any remaining policy proceeds not needed to repay the loan are paid to the owner’s named beneficiary and can supplement his personal life insurance to help offset other financial needs that arise from his premature death.
Borrowing from Family and Friends
Many businesses would never have been started if family and friends had not helped to finance the start-up. However, for most business owners, that may be the last resort. If the owner must borrow from family and friends, everyone involved must understand that the return on their investment will be reduced (or even lost) if additional capital has to be raised in the future from equity investors (non-banks). This is because early investors (family and friends) may be taken advantage of (or be cut out in some cases) by later equity investors. The point is that critical analysis needs to go into capital needs planning when launching or expanding a business. They need to think about how additional capital raises will be handled BEFORE the business is launched.
I am not the expert when it comes to all the options and the requirements of each. It is important to do your research and partner with someone that has experience and options that fit your needs.
What I do know very well is that if you have a business, it is important to make certain that you talk to an experienced Estate Planning attorney in your state to discuss succession planning for that business. You need to make certain you have a plan in the event you become ill or when you pass away. If you are a North Carolina resident and would like to discuss your business and estate planning needs, please call us at (704) 843-1446 and we would be happy to see how we can help you, your family and business.