Should You Invest or Lend Money to Your Business?

One of the startup’s common challenges is funding. Most commercial banks are unwilling to risk lending to a business with no credit history. Getting committed investors can be pretty hard too.

Although there are various other sources of funds for startups such as crowdfunding and peer-to-peer lending, you will need to invest some of your own money into the venture. This is referred to as a capital contribution.

You can give the funds to the business as either a loan or as equity. Be sure to classify the money appropriately. Here are the reasons proper recording of the funds is important:

  1. In case of a limited liability company or corporate, mixing personal and business funds could make you lose the protection from liability. If the business fell into liquidity problems, you would face major losses.
  2. Accounting and taxation become easier since the funds are properly defined as either debt or equity.
  3. It is clear how much the business owes you or how much ownership you have. A clear definition of ownership is especially essential if you are in a partnership.

Lending Money to Your Business

A loan to the business has to be treated like any other debt. Get a business lawyer to set up the paperwork for the loan. The contract should include the exact amount lent out, the maturity date, the interest charged, and the period of repayment. It should also be clear on the terms and conditions of the loan, and the consequences of defaulting.

Even as the business owner, you do not get special rights to collect in case of bankruptcy. Your rights are equal to those of other creditors.

Having a loan agreement provides validity to the loan and prevents tax issues. The interest you earn from the loan is taxable as personal income, and as a deductible expense to the business.

Advantages of Lending Money to Your Business

Loans earn interest, and although this is your business, some extra money can help with personal bills.

Lending a loan to the business makes you a creditor. In case the business goes into bankruptcy, the loan agreement separates you from the business and makes you eligible for receiving payments before investors.

Disadvantages of Lending Money to Your Business

Looking at it from the business owner’s perspective, the loan interest is an extra expense. The loan also comes with a strict maturity period, and for a startup that is yet to become stable, it could be financially strenuous.

The business retains its profits. Other than the required interest in the nation 21 loans, any other profit belongs to the business. It can be reinvested and used to expand the enterprise.

Investing in Your Business

If your interest is in making the business grow, you can provide funds in the form of investment. The funds will be accounted as owner’s equity or retained earnings, depending on the structure of the business. Ensure that there is paperwork to prove you are an investor or shareholder in the business.

You could deposit the amount in the business bank account and record it under the owner’s capital account. Alternatively, form a corporation and buy its stock. It opens an opportunity for other interested investors, but if you want to buy all the stock, that’s okay too.

The only personal tax obligation from the investment is on draws, bonuses you earn, dividends paid, or capital gain.

Pros of Making an Investment

By investing in the business, you retain ownership. External investors require a share of profit and depending on the shares owned, they could get involved in the management’s decisions.

By personally making an investment, there is better financial security for the business. External investors can withdraw their investment leaving your enterprise in a financial crisis.

Cons of Choosing to Make an Investment

In this case, there is no surety that your investment will break even. Like with any other investment, you could lose or gain.

In case of bankruptcy, the creditors receive payment first before investors, and you are likely to not get your investment back. If your investment was large, losing it could put your future at risk.

Tips to Funding Your Business

Here are a few tips that can prevent you from getting into trouble with the law, stakeholders, and IRS.

1) Maintain separate bank accounts

To ensure that there is never a mix up in funds, open a business bank account. Release the full amount of the loan or investment funds into the account or write a cheque to the business.

2) Keep proper records

For audit and tax purposes, it is important to record every transaction properly either as equity contribution or a loan. If you are unfamiliar with the proper accounting entries, hire an expert.

3) Consult with professionals

It is important to talk to legal experts and tax professionals about your intent to fund the business personally. They can offer valuable advice on both options and advise you on the records and contracts required.

4) Inject funds you can afford to lose

It is normal to be optimistic about your business, but numbers don’t lie. According to the Small Business Administration (SBA), half of all business startups do not get past five years. Instead of channeling all your money into the business, put in just enough to get it off the ground and reinvest the profits.

If you are dealing with a startup, investing would be the better option. It places no obligation on the business, allowing it to grow. For an established business, providing a loan could give it the extra support it needs, and after maturity, you can get your money back with interest.

To easily qualify for a bank loan in the future, consider investing in the company rather than providing a loan. Lending institutions such as banks prefer funding companies with a balance sheet that leans more on equity than debt.

Investment is usually riskier than a loan since the profitability of the business is not assured.But for a loan, you are sure of getting the principal and interest, unless the business faces liquidity problems.

Sources of Funds

Considering that the business has a 50-50 chance of survival, using personal credit to invest or lend money to your business may not be a very good idea. Here are two sources to consider.

1) Savings

If you have some money stashed away in a savings account, you could use it to fund the business without accumulating debt. Ensure that the money goes to growth-oriented tasks such as purchasing efficient equipment that could generate returns on your money.

2) Retirement funds

You can dig into your retirement accounts such as the 401(k) savings, by taking advantage of the Rollover for Business Startup (ROBS). It allows you to withdraw cash from your retirement accounts and use it as investment capital without getting penalized.

In Conclusion

Your decision to loan or invest will depend on the intention and the risk you are willing to take. Consider the business’s need for future financing from banks, and your desire to maintain control of the company.

Weigh up both options, keeping the pros and cons in mind, and make an informed decision. Be sure to involve a lawyer to create paperwork that clearly shows your relationship with the business as either an investor or a creditor.

The paperwork should show the amounts, a clear expectation of repayment, terms and conditions, and the consequences of defaulting.

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