Families and friends are an important source of start-up capital for many small and home-based entrepreneurs. They are an accessible source of funds, with infinitely fewer hoops and requirements compared with formal lending institutions and formal investors. What could be easier than calling your Dad or your Aunt Melba or best friend Randy to lend you money for your business startup?
Sometimes, families and friends can even be your only source of funds. In fact, a study from Babson College said that financing from family and friends is:
Financing from informal investors and entrepreneurs is the lifeblood that supports both nascent and fledgling businesses. Informal investment amounts to more than $100 billion annually or, put differently, 1 percent of the GDP.
If you have bad credit, have no collateral or equity investment to put in your business, or if you have no experience in the business, banks will consider you too high risk and there is little chance you can fund your business through loans.
However, borrowing from your kin is not without problems. In fact, in many respects, it is even more difficult than getting a loan from a bank. Experts even advice that you should think twice in involving your family in the startup of your business (read the blog post “Accepting Start-Up Capital from a Family Member: Good or Bad?”)
Here are some steps to prevent unwanted problems when borrowing from families and friends:
1. Choose the right person.
Start with the right person to borrow from. You know the characters and personalities of your family members and friends, and the wrong person can force you to spend a lot of time and give you loads of stress. Some may not live down the fact that you borrowed money from them. Worse, they may act as if they own you and your business.
2. Understand that this is high risk capital.
Borrowing from family and friends entails the highest risk. Unlike banks or venture capitalists where your relationship is purely business, your personal relationship with the family member or friend is on the line (and can be jeopardized!) when you borrow from them. Think how you will face your father-in-law at the dinner table when you lost all his money. Or consider whether you are ready to throw out your relationship with your best friend since kindergarten. Personal relationships can be destroyed with the parties not speaking to each other ever again when bad investments happen.
3. Ask for money only when you are prepared and ready.
If you have an idea for a business that you think could work, do not immediately present the idea to your family and friends and ask to borrow money without doing research on the viability of the business. It is easy to get excited about eureka moments in business when you think you have stumbled upon the next great business.
Your relationship with your family and friend can better survive a business involvement if you present to them both the opportunities and risks involved in investing in your business. Nothing ruins a relationship faster than providing false promises on the basis that they can double or triple their money when they invest in your business. Treat your family and friends as you would a banker or an angel investor: do your research, prepare your business plan, and show how exactly the business is going to make money, do some number crunching and prepare your financials. With your research and business plan on hand, they can get into the business fully aware of potential gains and losses; and you show to them that you value and respect their investment.
4. Discuss how their investment will be structured.
You can choose to consider their investment as equity where they will share ownership of the business. Or you can consider their money as debt that you will repay after a pre-agreed period of time with appropriate interest.
How the borrowed money is handled is an issue that needs to be on the table before any money is exchanged. If you are not ready to give up ownership but your family member or friend expects to be part-owner of the business, then you need to straighten this out with them. The worst thing that can happen if for relatives and friends acting as if they own the business and make decisions for you.
If this is a debt, consider paying interest (though it sure can be so tempting to get the money interest free, after all, this is your beloved Uncle or Aunt). If you do not pay interest, you may be faced with tax implications. The IRS may consider no-interest loans among family members, including loans made below market rates, or at no-interest, subject to federal gift tax. Consult your accountant on the implications of this type of money.
5. Put everything in writing.
They may be your family and friends, but if we’re talking about money, is it best to keep everything in writing for both your protection. Handshakes are never enough. Having a contract or a document specifying the terms and conditions of the investment will help ensure that the agreement stays professional.
Plus, if the loan is formalized, the lender may be entitled to a tax deduction as “bad debt” in the event that the business fell apart and you cannot pay the loan. That can give your source of funds more confidence in giving you the money you need.
Recommended Books on Raising Start-up Capital:
- CrowdFund Your StartUp!: Raising Venture Capital using New CrowdFunding Techniques
- Raising Venture Capital for the Serious Entrepreneur
- How to Get the Financing for Your New Small Business: Innovative Solutions from the Experts Who Do It Every Day
- Financing Your Small Business: From SBA Loans and Credit Cards to Common Stock and Partnership Interests (Quick Start Your Business)
- Get Your Business Funded: Creative Methods for Getting the Money You Need
- Pros and Cons of Financing a Business
- Evaluating Financing Options for Your Business: Myths and Facts
- Understanding the Kinds of Capital for Your Business
- Does Borrowing to Pay Debt Make Sense?
- 12 Tips for Getting Your Bank Loan Approved