July 10, 2017
Frequently, clients desire to lend money, seller-finance the sale of their business or other asset, buy and then lease out a building, or engage in some other business transaction because they are motivated by favorable business terms the transaction provides on its surface: A high rate of interest, a good return under a lease, or a more promising sale price than otherwise the seller would obtain, for example.
This entry asks a prospective private lender to think twice about the risks associated with this activity and to take as many steps to protect himself as possible under the circumstances.
Who is the “lender” and who is the “borrower”
For purposes of this entry, there are many circumstances in which a party is a “lender” and another is the “borrower.”
- Obviously, a simple monetary loan in which there is a lender and borrower is one such transaction.
- Another occurs where an investor either owns a building and desires to rent it, or purchases one for leasing purposes. In addition, as a part of a leasehold transaction, the landlord may be putting into the premises significant sums in “tenant buildout costs.” Here, the renter is “using” the landlord’s money, his credit, and his asset, in exchange for monthly (read: deferred) payments. This is a form of “loan.”
- When a seller is selling his busines, his building or another asset, and does anything other than take back 100% of the purchase price at the time of conveyance, he is a “lender.” (And the worse situation is where the seller is taking a subordinate position to a lender who gets a first mortgage or other lien on the assets acquired. In such situation, the liklihood of the seller getting his “loaned” funds is significantly impaired, and the chance of default significantly higher.)
- Even co-signing a loan or a lease, or guaranteeing the debt of another, is “lending” your credit to the co-borrower.
Four important factors to consider
But consider these factors before “lending” your money, your asset, and your credit to a third party:
First, ask yourself: “Why can’t this buyer get conventional financing?” Banks are in the business of assessing and taking the risks associated with lending. If this “borrower” does not qualify for a bank loan, why should you be in the business of being a lender? Have you really fully assessed the risks of lending to this “borrower.”
Banks know experientially and actuarially the “warning signs” that predict loan defaults. Among these are an inability to come up with an adequate down payment, a poor credit score, a history of litigation, and other warning signs. I spoke with one lender recently, and they said they will never lend to people who fail to pay their taxes — ever.
Second, in my experience, a buyer of an asset is much more likely to raise defenses and counterclaims against a seller than the buyer would be able to as against a third party lender: Fraud in the inducement of the sale, property defects, misrepresentations in the business accounts, and simple contract breach. Buyers will raise any and every excuse and defense against paying money they owe.
Third, the more desperate the “borrower” is, the more likely he is to agree to generous transaction terms: a high rate of interest, a high sale price, or some other above-market remuneration. And — I say this based on experience — borrowers who have no intention and no ability to pay back the “loan” are the most willing to agree to generous lending terms.
Fourth, if you are going to leap (into the position of being a lender), at the very least look first: do the kind of due diligence that a lender would — a credit check, a background check, reference checks, and a simple check of court clerks sites and bankrupcy court history for obvious signs of fiscal distress.
The ABCs of improving your position as a lender
So, you have made the decision to “lend.” What steps can you take to improve your position and increase the liklihood of getting your money paid back, with interest?
A. Certainly ask for a personal guarantee of any “loan” to a corporate entity. Accepting simply a corporate signature, whether of a note maker, a tenant or the buyer of an asset, is asking for trouble, unless that company’s creditworthiness has been thoroughly ascertained
B. Don’t be shy about asking for the personal guarantee of the principal’s (or principals’) wife (or wives). If the borrower is earnest about putting their name, their assets and their creditworthiness behind a promise, and they have asked you to extend credit to them — then shouldn’t their wife also stand behind the obligation? Stating it differently, the most common and most obvious dodge of debtors avoiding their creditors is to place their assets in the name of their wife. Don’t let them avoid their obligations to you so easily.
C. Are there third parties who can guarantee the debt? A business partner? A parent? Who is interested in the success of this borrower’s business such that they would be willing to stand behind its obligations?
D. Look for assets to lien. Does the “borrower” (or his wife) own a house, stocks, jewelry, accounts receiveable, or equipment or inventory in their business? Are those assets presently free from any first lien against them? If so, and if the borrower is earnest about paying back your debt, then he should not have qualms with providing a security interest against those assets to stand behind the loan. (Note: Please consult an attorney about how to properly take a lien in various assets; it can be tricky.)
E. Would some patience or a reduced price yield either a cash buyer or enable the buyer you have to go and get a bank or other third party loan? If so, it may be wise to take one of those options.
Lending is an ultra-hazardous activity that should not be undertaken lightly.
There are exceptions where the seller’s main motivation is not necessarily getting payback of the loan: a parent helping a child; a business or building owner who is getting a great sale price for the asset, and perhaps much of it in cash; or simply a weak market with few buyers. And so long as our clients enter into a transaction understanding the risks of being a “lender,” we are fine with that decision.
But we see many clients seduced by more favorable terms from a borrower or seller-financed buyer who desperately needs their cash versus a stingier cash buyer.
Our suggestion: Think about taking the money and running instead.
The risks inherent in being a lender is why they say: “Cash is king.”