In 1986, my soon-to-be business partner and I discovered a remarkable treasure: eight million antique mother-of-pearl buttons, the remaining inventories of now-closed button factories that operated on the banks of the Missouri River a century ago. A few months later, we uncovered an equally remarkable treasure: a $225,000 bank loan that would allow us to buy the buttons, launch a jewelry business, and fulfill our long-standing dream of becoming entrepreneurs.

Many aspiring small business owners, of course, jump at any cash that is offered. The prospect of raising money looms so large, it appears to be a greater obstacle to success than hiring staff, making products, or finding customers. We were no exception. After raising $75,000 from family and friends, we eagerly pursued 10 banks for the balance of the $300,000 we needed to buy the buttons. When the loan came through, the dream had begun…but so had the nightmare.

Indeed, the financing we believed would enable us to launch our business, Eastwind Trading Co., actually wound up killing the company, driving both my partner and me into personal bankruptcy. From the perspective of 10 years, it is easy to identify the root of the problem: the terms of the loan were so burdensome that we were doomed from the start.

Bad Loan, Insightful Lesson

Our experience serves as a lesson for entrepreneurs smitten with those alluring words from respectable commercial lenders: “Your loan has been approved.” Relieved not to have to deal with such netherworld alternative financing techniques as credit-card debt, some aspiring owners don’t put enough emotional distance between a bank’s money and their needs. They don’t analyze whether a bank loan is right for them. What follows is a look at our story, which I offer with the hope that your story will have a happier ending.

Let’s begin with what we did right. As young women in our early 30s, we carefully charted a plan for building a business while keeping roofs over our heads. I put up most of the initial start-up funding and kept my day job as a marketing employee for what is now Sprint, and my partner shut down her advertising agency to contribute sweat equity. Our idea for upscale jewelry crafted from the buttons was on target. The first year, we easily secured about $150,000 in orders from such stores as Nordstrom and Fortunoff.

So what went wrong? One major problem was unrelated to the financing. The manufacturer we had contracted couldn’t make a quality product in large numbers. A lot of the jewelry fell apart when it got to the stores. We were loathe–for whatever reason–to venture beyond the local area to secure another vendor. Another misstep was that we bought too much raw inventory–enough for 20 years–because the seller offered the buttons only as a complete lot.

Terms of Inducement

Most of our company’s problems, however, were related directly to our accepting a bank loan that wasn’t right. With the benefit of hindsight, we realize now that we should have been alarmed by the following four red flags:

1. The Guarantee
   Unlike the nine banks that turned us down, our bank insisted on a guarantee from the U.S. Small Business Administration. That meant that if we defaulted, the SBA would repay 90 percent, leaving the bank at risk for only 10 percent. That, in turn, removed the bank’s incentive to work with us. Whereas banks routinely assist borrowers in trouble, we were ignored when we encountered problems.
2. The Repayment Terms
   According to a financing rule-of-thumb, when purchasing inventory, borrowers repay over the course of using their inventory. In contrast, our bank demanded that we repay within four and a half years, even though we were buying enough inventory for 20 years. In retrospect, of course, we should have negotiated to buy only a portion of the inventory, threatening to walk if the seller refused. That the bank didn’t override our naivete, however, was inexcusable.
3. The Salary Limit
   At first, the bank wouldn’t allow us to draw salaries, arguing that we shouldn’t take cash from the company until we had repaid the loan. That was unrealistic. We soon discovered that our plan for covering living expenses wasn’t adequate. Having closed her advertising agency, my business partner was forced to take a part-time job, and I continued to work full-time at Sprint. (Eventually, the bank agreed to a $30,000 salary for my partner). Our day jobs sapped us of the energy necessary for reacting quickly and decisively at our company.
4. The Collateral
   The bank demanded that we put up all the company’s assets as collateral. That meant we were not able to negotiate a short-term line of credit for financing accounts receivables–the very lifeblood of fast-growing businesses.

Taken together, these red flags foreshadowed a cash crunch that would eventually keep us from attending to such fundamental problems as finding a new manufacturer. By 1989, Eastwind Trading had dissolved and we were bankrupt.

With the wisdom that comes from experience, I’ve learned that bad loans don’t just happen to good entrepreneurs. Rather, smart entrepreneurs are tempted all too frequently by the lure of a bank loan–even a bad one. So take your time and evaluate all loans carefully. Sometimes being granted a loan can be the worst thing that ever happened to your business.