School of Hard Knocks: Stupid Lending 101

The School of Hard Knocks (SOHK) has a lot of classes, including “Stupid Lending 101“.  The following is my real life Case Study where disaster struck from not lending money properly.  Following that is a set of Guidelines for responsible private lending.

The Case Study

In my mid 30’s, my wife and I were focused on our young family and financial security.  We had saved up a nice chunk of money.  Along comes a doctor friend of mine who introduced me to a prominent business owner.  I met with him and was duly impressed by his beautiful office, fancy car, large enterprise.  Let’s call him Jack.  Jack regaled me with his expertise, experience, and name dropped some prominent people.  I felt he was someone worth knowing.

It did not take Jack long to bring up his liquidity requirements.  All of the major shareholders in the business needed to provide a cash call in order to maintain their shares.  Jack was personally not liquid, and needed someone like me to get him through the next 18 months, when the restructuring was planned.  I must admit at the time I did not understand it all, but he sure made a good case.

I knew nothing about private lending, and I really liked the prospect of 18% interest.  Besides, I could see the dozens of employees hard at work, and his personal trappings of (the appearance) of success.  So, I agreed to review the lending documents he sent me and think about it.  My wife also knew him approved of his character.  

So, we loaned Jack the money, with the assurance that we would be paid back in 18 months, and we would get interest payments every quarter.  And we did start receiving them.  Nice juicy interest payments, and it was a good feeling,  After 9 months, the good feelings abruptly stopped.

Jack, this prominent business man and lawyer, was declaring personal bankruptcy!  He was still a Loan Guarantor on a real estate deal that he had long ago exited, and all his ex partners had declared bankruptcy.  In his plush office, he explained to me that I was behind a whole bunch of creditors, and I would be lucky to get 5% back.  Jack told me not to worry, that he would pay me back when he got back on his feet, which would not be long.

It is hard to describe the the feeling of a few year’s savings melting away.   Shock, Anger, Stupidity, Embarrassment, and Sadness are an unpleasant cocktail.  It was only then I realized I was enrolled in the School of Hard Knocks “Stupid Lending 101” and I passed with flying colours!

Fortunately, Jack is a good man.  He did manage to pay back the loan over the next 4 years, even when he had no legal obligation to do so.  I am still grateful to him for that.  Jack limited the tuition to the SOHK to a hard emotional lesson with limited financial repercussions.  The 4-year belief of having lost that money was lesson enough.  I got out but the skin on my teeth.

Lessons Learned:

1. Private Lending requires due diligence.
2. High Interest Rates means high risk.
3. Beautiful Offices, Great Pedigree can be on shaky foundations.
4. No collateral loans puts you behind other creditors.
5. Bankruptcy rules mean the debtor is not obligated to pay the loan back.
6. The person who declares bankruptcy can drive a nicer car and have a bigger house than you.
7. Bonus Lesson,  Jack is a good man.  Thanks Jack, for paying me back when you did not have to.

Post Graduation  (Epilogue)

This lesson stung.  But it really helped me, and I have done private lending much more successfully.

A couple of year ago, a business acquaintance was struggling with growing their company.  Their receivables were 90 days out, but their payables were due in 30 days.  Their AAA customers were growing their business from $1M to $2M, and they basically needed to cover 60 days of cash in order to make 40% margin.  

I investigated.  I found out that one of the partners had a fully paid condo, and I gladly placed a lien on his property and loaned the money at a high interest.  I also taught him how to get a Home Equity Line of Credit so that he could access that equity and not need my cash in the future.  In that case, I liked the borrower, I secured the loan against collateral, and I ultimately made very good profit with acceptable risk.  And the borrower was very grateful, as I helped him grow his business, and taught him how to access his own credit.

I was paid back and I can say we are now very good acquaintances to this day.

My Guidelines

I do not go out of my way trying to lend money.  However, when approached, I have established some very basic guidelines.

1. Personal Connection.  No unsolicited borrowers.  I must know or be referred to the borrower.
2. Purpose of Loan.  I understand and agree with the purpose of the loan.
3. No collateral, no loan.  I don’t do non-collateralized loans.  Period.
4. First Creditor.  Do not be in second position.
5. Use a Lawyer.  I always have my lawyer review, and send the bill to the borrower.
6. Background Check.  I get a criminal background check.
7. Clear Payout Terms.  Quarterly Interest Payments, and deadline for the principal.

Note:  When it comes to real estate, there are much more specific tactics like getting appraisals, closing in escrow, being named in the insurance contract, lending within a Limited Liability Corporation, using a Mortgage Broker, and even more tactics when financing a renovation or construction.  I dabbled in this once, and never again.  I’m just not interested.  The main reason is that I prefer to use my cash for longer term real estate deals.

How do you like the SOHK stories?  Comment below.  I’ll post more of my failures. and what I learned from them…