What are the drawbacks of a zero interest loan?
Should I take a zero interest loan in exchange for 5% of before tax profits to the lender, for as long as the business operates? What are the drawbacks of this agreement? I will be opening a spa soon and received this offer from a co-worker.
Although I can always use the cash, I have the feeling that this deal will be expensive in the long run. My guess is that 5% before taxes will be equivalent to almost 8.5% of after-tax profit.
I have no idea how much money you will make in your business or how much money they are talking about giving you. If you are giving up a percentage of your profits, you are basically selling equity, not getting a loan. You just need to look at the value the money you are receiving, how much more money you and your business can earn as a result, and compare that to the future value of the 5% of profits.
You are asking a very interesting question and one which should be thought out. I think you have to compare what you would do with the cash amount of the loan against how much money you foresee the business actually making during the course of the loan, and then over the lifetime of the business. Typically, if you believe the business will generate cash and then grow for a long period of time and be successful, giving up that income stream is not smart. For example, if you got a loan of 100K over three years, and could invest the cash at 5% return per year, you would essentially come out with a little over 115K after a three year period. If you believe the amount of cash you will get from the business will be over that return of 5% per year, or 15K ish for three years, then you don't make the loan. If you believe the hurdle rate is higher, say 8.5% after tax, the threshold becomes closer to 126k on 100k loan- or 8.5%*3=25.5. So what you see is the better the business does, the more you will be giving up. The question you really have to answer is how well do you think the business will do, not just today, but for a long period of time. I hope this helps answer your question.
Yale Bock, CFA
Y H & C Investments
No, you shouldn't take the loan. But if you still want to do so, then give me a call. Five-percent of your pre-tax profits for the life of the business is extremely steep and is tantamount to buying an equity stake in the profits (though not technically in the business). In essence, the co-worker is becoming a "partner" and could make your life miserable. To understand this, put yourself on the other side of the table. What if the co-worker agreed to accept your loan for 5% of the spa's pre-tax profit. What's the first thing you would look for?
What are the pre-tax profits!
And if the profits were less than what you had expected (resulting in having less money to be paid out to you), what would you want the owner to do?
Raise the pre-tax profits!
How? Maybe by taking less of a salary. Or firing the owner's niece. Or turning in the car the owner leased. Or ... You get the idea. You would want the owner to maximize profits in order to maximize your return. And the owner would quickly become annoyed with your demands.
Instead, go back to your co-worker and tell them if they want to invest in the spa you will let them loan you the money, but at a higher rate (say, 8%) for a specific term. Or you will take an interest only loan at 8% with a balloon payment in 5 years. Or something else that would preserve your freedom while satisfying your need for cash.
This is a really fun question and assuming your the lender, you may well be in the driver seat. Always remember, that there's a chance that the business will have no profits and 5% of nothing when I went to school has always remained nothing. Instead, if they really need your money, you can make a 0% interest loan which will create phantom income from the IRS's perspective and instead of taking 5% of the before tax profit, take 5% of the gross. There's always a gross if there's a business. If the business fails, then everybody loses including yourself. However if the business is reasonably profitable 5% of the gross will always allow you a distribution and the distribution should come monthly. In other words, in exchange for the loan the business will have to operate on 95% of its gross revenue and you may still be entitled to percent of the profits depending on the remaining terms of the deal. Hope this helps and good luck