Monday, April 2, 2012

We Would Rather give you a Loan

I talked about this briefly in another post, but what does it mean when someone says they would rather give you a loan than take any more of your equity?  Why would they do this?  Just to be nice guys?  Not exactly!  

A loan is basically a guaranteed return.  Of course, there is some risk, but less than the risk of equity.  Why?  Because if you go out of business, equity is worth $0 and a loan (i.e. debts) gets the first money out...  So if you fire sale the business, debt is paid (in full, plus interest and other provisions) first...then equity is paid with the remaining proceeds.  Another provision that is common is that if you sell the company (even in a fire sale) that interest is paid in full - i.e. to the term of the loan.  So if you have a 3 year loan at 10% for $1M and you sign that today and you happened to sell tomorrow, you might owe the $300k.

Moral of the story...know what you're getting into before you sign up.  As I always say, if it sounds too good to be is.  So don't assume anything - ask!

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