The legal pitfalls to avoid when taking a loan for your startup

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In the past few weeks, we've been exploring various sources of start-up funding. Just to recap, we've tackled equity and grant funding.

Today I will introduce debt capital. With debt capital, a business borrows funds from a lender and undertakes to repay the principal amount together with interest periodically. One distinct feature of debt is that the funds must be repaid. Unlike equity financing, the lender does not get any stake in the company. His interest in the commercial transaction is the interest he will make.

Debt capital or loans are usually offered by financial institutions including banks, micro-finance institutions, and Savings and Credit Organisations(Saccos). Lenders have stringent requirements before they can issue funds. Most are reluctant to lend to new businesses due to a lack of historical records.

Lenders also consider the cash flows of a business before issuing funds. Such stringent requirements have made it difficult for startups to access funding. Some start-ups circumvent these stringent requirements by borrowing against personal assets such as land. In some cases, some start-ups get guarantors for the funds they will borrow.

MFIs and saccos have less stringent terms when it comes to start-up funding. The downside is that the amount a start-up can borrow is smaller than the traditional bank lending system. Most banks have a provision for unsecured loans which means that the start-up can access debt without giving security. However, the amounts are limited and stringent terms must be met by the business.

I would advise you to speak to a financial advisor in the event you intend to take a business loan.

There are many factors that you must consider even before taking out the loan. The first is whether your business can repay the loan installments in the period and amount set out by the lender.

It is not wise to take out a loan if you are not sure that you will be able to repay according to the lender’s terms. Doing so will expose your business to liquidity and default risk. Most of your cash flows will be channeled towards servicing the loan and if you do not make enough cash flows then your business operations can be crippled by debt.

If one defaults on a business loan, then there are a lot of penalties that may be resorted to by the lender. These include charging default interest or even taking over your business in what is known as statutory management. The lender can also wind up your business in the event the loan remains unpaid.

Most businesses that take business loans do so to finance an expansion phase where additional revenues are almost certain.

There is a lot of legal documentation that goes into the issuance of a business loan especially if you are providing security for the loan. You will be issued a letter of offer and documentation to secure your asset in favour of the lender. The security document will be registered as a charge, mortgage, or debenture. It is wise to involve a lawyer in the process as your lawyer will explain to you some of the conditions of the debt facility.

In the event you repay the debt in full then another process known as discharge the security must be undertaken to release your business from the borrowing arrangement.

I hope that more lenders will lend to start-ups. In as much as they are deemed to be high-risk investments. The potential for high returns is also real.

The writer is the founder of C Mputhia Advocates