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Monday, October 1, 2012

Bank Loans For Small Business

Many small business borrowers have difficulties with banks because they think banks invest in businesses. Banks are lenders, not equity investors. Lending money to a small business is a much different proposition than investing in a small business.

In evaluating a loan request or investment opportunity, lenders and investors, respectively, attempt to identify potential risks and balance those risks against potential reward. The potential reward for a bank is the repayment of the loan plus the interest income earned. The potential reward for an investor is the selling price of their ownership interest. A bank is looking at an interest income potential equal to a fraction of the loan amount. An investor is looking at an investment income potential equal to a multiple of the investment amount.

Debt differs from equity investment in three significant ways:

1. Debt must be repaid; equity does not. A bank loan requires principal and interest payments in a timely and structured fashion.

2. Debt is normally collateralized; equity is not. A bank loan is frequently collateralized with business assets and, in many small business situations, supported with the personal guaranties of the owners and further collateralized with personal assets.

3. Debt holders are cushioned from losses by equity investment holders. Debt holders are paid prior to equity holders in the event of a business liquidation.

Many small business borrowers are looking to banks to be investors in their business. That is not the role they "intentionally" play which causes difficulties.

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