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Family & Friends Business Loans: Easy Money or Recipe for Disaster?

Finding sufficient capital to fund a startup can be a real challenge. Unless you’re independently wealthy, you’ll probably need to borrow money to cover the initial expenses of starting a business. Banks and other traditional lenders are often reluctant to make loans to companies without a history of good business credit. Some owners finance their startups with credit cards, personal savings, home equity loans, or 401(k) withdrawals, but these methods have the potential to seriously deplete an individual’s financial resources. Crowdfunding may open your company to scores of potential lenders, but many entrepreneurs choose to keep things closer to home.

Turning to family and friends for business loans is fairly common, and it’s easy to see why this can be an attractive option. The people that care about you may be predisposed to trust your judgment, whereas a traditional lender usually relies upon your business credit history and financial projections. Family and friends may also extend more favorable terms than a bank, providing a lower interest rate and longer repayment schedules.

Before you get grandma on the phone, it’s important to consider the drawbacks of these loans. First of all, a failure to clearly define the terms of the loan can cause conflict down the line. When should the money be repaid? Are there consequences for late payment? What happens if the business fails and you lose the money? It can be extremely stressful for both lender and borrower if things head south – especially when they see each other on a regular basis. Your friends and family may also run into financial difficulties of their own, and could ask for full repayment on short notice.

Remember, the impersonal nature of traditional lenders can work to your advantage, as most banks will make sure terms are defined and consequences are enforceable. They’re also less likely to call you at midnight in a desperate search for cash.

If you’ve weighed your options and decided that family and friends are a viable source of business funding, you’ll need to be organized and transparent. Here are some tips that may help avoid the negative consequences discussed above.

#1 – Come Up With a Funding Strategy

It’s usually easier to obtain a large number of small investments than it is to secure one or two substantial loans. While your family and friends may have faith in your capabilities, they probably recognize that it’s difficult to achieve success in business. Asking for smaller amounts can help minimize individual risk, and makes writing a check more palatable to some investors.

#2 – Decide Upon an Investment Type

Your family and friends are probably not going to give you free money. In fact, you should be confident enough in your idea to offer them a potential return on their investment. This may be in the form of repayment with interest, or equity in the company. Beware of extending special perks like free products or services – these can cost you if investors take advantage of them too often.

#3 – Prepare Your Pitch

This is personal, so your pitch will have to cater to individual investors. Those closest to you will probably not require a formal business plan. However, your investment banker uncle may ask tough questions. You need to be able to come off as professional and organized. Don’t over promise or present flowery projections – everyone should understand the potential risks, no matter their level of financial know-how.

#4 – Put the Terms in Writing

If you’re going to be dealing with a multitude of loans, you need to keep everything tightly organized. Forget about the fact that the lenders are your loved ones and treat the transaction as you would any investment. Make sure to discuss the terms in detail. Settle on schedules and interest rates. Have a lawyer draw-up a contract or promissory note. Your family and friends may shy away from dealing with an attorney, but you must assure them that it’s in everyone’s best interests. Your father may want to give you an informal “gift,” but remember that miscommunications or misunderstandings can have serious consequences for your business.

#5 – Keep Your Investors Updated

There’s nothing worse than investing in a family member’s business and then not hearing from them for months. It’s important to keep in touch with your investors to let them know how the venture is progressing. Even if the money was given as a gift, keeping your investors in the loop may reassure them that their funds are being put to good use.

All it takes to accomplish this is a monthly or quarterly email newsletter sent to the interested parties. This will keep them close to the action. Should your business require additional funding in the future, these updates may increase their confidence that the company is on the right track.

There are risks any time a business owner takes out a loan. No matter where your financing comes from, transparency and objectivity can help both lender and creditor prepare for success or failure.

Interested in finding funding sources for your small business? Visit Access to Capital for more information on ways to finance your company.

 

Photo Credit: Flickr.com, David

 

Gregory Sidor

Author:

Gregory Sidor is a freelance writer and online content editor. He’s worked on websites for Disney, Fox Interactive, and the Los Angeles Daily News. His interests include finance, technology, astronomy, and history.