As a business owner, you probably want to know, when is a good time to take out a loan for your business? The prospects of growth are so tempting. Yet you have heard that business loans are evil and will kill your business.
Taking a loan for your business is indeed dangerous. It’s risky not only because lenders are evil and can force you to liquidate/sell your business, personal assets and garnish your personal income. It’s risky because business itself is packed with uncertainties.
Imagine yourself running a cafe for 10 years in your local suburb. You are the only cafe there, every residents come to you for their daily caffeine hit. It’s a small town with only 1,000 residents. Suddenly, your employee resigns and opens a rival cafe. Your income suddenly gets halved, in an instant.
If you have a loan, the loan repayments won’t get halved. How are you going to repay the same loan, with half the income?
There are 2 situations where it is probably wise to take out a business loan:
- When the loan amount is reasonable in comparison to your safe surplus income
This is when the amount of your business loan is not too big, in comparison to a surplus income level which you are very confident to easily earn.
I like to benchmark the loan amount against my yearly salary, which I was earning before I started my business, and I know I can earn again if I get rid of my business. I know that if I need to close down my business, I can work for another company, and earn $50,000 a year without too much difficulty.
Hence, for me, a business loan of $50,000 may be reasonable. If my business fails and I lose everything, I only need to work for 1 year “for free”, and I can pay off my business loan within 1 year.
If you have a family, you will want to take them into account. Can you get an extra $50,000 on top of the minimum living expenses for your family? Does your wife/husband have their own job? Can they get their own job to contribute towards the family’s expenses? Can either of you easily get a second job & work more? Do you have kids which require your time and attention, i.e. you cannot get a second job? Do you have parents or family members you can fall back on, so you don’t need to pay rent and can share some of the household bills temporarily whilet you get back on your feet?
Because I have parents I can fall back on, my safe yearly income is the same as my safe yearly surplus income. Because I essentially have $0 mandatory expenses. If you are not in this fortunate situation, you would want to deduct your mandatory living expenses, from your safe income.
Business is a high risk, high reward venture. It’s somewhat similar to buying a lottery ticket, or a raffle ticket. The probability of losing is high. But the rewards are huge, and the rewards make it worthwhile to take the risks.
Each person’s time horizon may be different. For me, I consider it reasonable to gamble away 1 year worth of safe surplus income (employment income I can easily get from another company, less my mandatory living expenses).
- When the loan amount is reasonable in comparison to your net wealth
For the majority of you, a safe yearly surplus income is $50,000 or even less than that. Does that mean, it would be unwise to take on a business loan of more than $50,000?
The answer would depend on how much assets you have. More precisely, your net assets (after deducting your mortgages and debts). If you have a house worth $1m with a $800k mortgage, your net asset or net wealth is only $200k.
At the start of your career and entrepreneurship journey, your yearly income is typically bigger than your net asset.
But as you go through this journey, you save a portion of your income every year, and your net asset will become much bigger than your yearly income.
What’s considered a reasonable net wealth to gamble away?
For me, I look at absolute values rather than percentages of net wealth.
I want to maintain around $1m of net wealth, as this allows me to live relatively stress-free and maintain financial freedom. The Four Percent Rule of retirement says that a typical (elderly) retiree can safely withdraw 4% of their retirement account each year, and this likely will result in their retirement account only becoming depleted by the time they… pass away. But when I’m young, I don’t know when I will pass away, so I probably want to withdraw only 3% of my investment account. This should hopefully result in my investment account maintaining its value over time, and even keeping up with inflation.
A $1m investment allows me to withdraw 3% per year, or $30,000 per year. Being single with no kids, I believe $30,000 a year is sufficient to pay for my mandatory living expenses. In fact, I’ll have more to spend each year if I have a job, but I like being financially free so I can bum around.
With this in mind, any portion above $1m can be gambled away. Before I reach $1m net wealth, I will limit my business loan to $50,000 (which can be covered by 1 year worth of salary, if I go back to living with parents).
A couple of questions arise:
- Do I count my owner-occupied home in the “net wealth” calculation? I do, because I know I can sell it, invest the money, and then rent somewhere cheap, perhaps in Far North Queensland. Chances are, my business will do really well, I will 10x my money, and I will never need to sell my home. But if my business fails, I sell my home, use the proceeds to pay back the business loan, and invest the remaining amount.
- Why don’t I sell the home or investment asset to begin with, and use the money to grow the business, instead of taking a loan? Because my home or investment asset will most likely grow in value. Hence by not selling my asset, I have 2 helpers working for me: my passive investment asset, and my active business. Chances are, both of them are great workers, and help me build my wealth faster. I would want the expected return from my passive investment asset to be more than the cost of the loan. If this is not the case, it would make more sense to sell that passive asset and fund the business with cash (although sometimes it can be better to fund it with a loan which is temporary in nature, for example if I’m not sure that I’ll be able to buy the asset again after I sell it).
To summarise, at the start of my entrepreneurship journey, I would take out a business loan of up to $50,000 if I’m confident that I’ll get a return of more than the cost of the loan. I will then wait until I have $1m in net wealth, before I take on a bigger business loan. When I do that, I’ll try to make sure the expected return from my passive investment is more than the cost of the loan. Otherwise I might just sell that passive investment and fund my business with cash.
The above discussion is about getting a cashflow loan to pay for expenditure such as employees and advertisements. If I’m buying a durable asset for my business which can easily be sold again, I may be more willing to borrow more. This is because at any time, I can sell that asset to substantially pay off the loan balance.
Are you looking for a low doc business loan, without having to provide tax returns? Or perhaps even a no doc business loan, which is only secured against your property/asset?
Please reach out to discuss what we can do for you!