Whether you’re an established small business owner or a budding entrepreneur, you’ve likely come up against the same issue at one point or another: Where can I get my hands on some financing?
Financing is one of the most misunderstood aspects in all of business ownership. You don’t look for financing just when you have cash flow trouble and you need a financial lifeboat. In fact, financing is often used to help a successful business become even more successful—by opening up the possibility of expansion, renovation, or other improvements that you otherwise couldn’t afford.
In this situation, lots of small business owners turn to their trusted inner circle—friends and family members. Unlike banks, online lenders, or venture capitalists, you likely don’t have to jump through hoops to get financing from your buddies. Plus, they may be way more generous with their interest rates than a bank would ever be.
It’s understandable why getting a loan from a friend or family member would be tempting. Quick access to funds, at potentially low rates, without having to file paperwork? Sign us up.
It’s not that simple, however—it never is. There are a few reasons why you should avoid borrowing money from friends and family, and instead apply for a loan with an established vendor.
Without paperwork, things could get messy.
When you accept a loan from a friend or family member, you mix your business and personal life.
In an effort to reduce the stress and workload that a traditional loan entails, most family and friend agreements are informal. Maybe there is a written agreement, maybe not. Maybe that agreement is binding in some way, maybe not. Oftentimes, it’s based on the implicit trust that close circles have for each other.
But it’s that mixing of business and personal dealings that creates confusion, discontent, and perhaps further legal action that both bogs down business owners and threatens familial ties.
Unless you have a clear, written understanding with your lenders—no matter who they are—you will inevitably run into issues as it pertains to input, feedback, and payout. Do your “lenders” understand that their loan doesn’t give them veto power over business decisions? Do you understand that the business failing doesn’t absolve you of the responsibility of paying your loans back?
Family and friends may expect to not do paperwork, or may refuse outright—even if they have the best intentions. That’s where things get messy.
There are still tax implications.
When major amounts of money change hands, no matter the circumstances, the IRS is likely to get involved—and a cousin loaning you a substantial sum to cover refinancing, for example, is no exception.
Those who think a family and friend loan doesn’t require any paperwork are entirely misguided: You’ll still likely need a signed promissory note, a written repayment schedule, and other documentation that stands up to IRS scrutiny over private lending
Not clarifying whether this money is officially or a loan or a gift can also invite IRS investigation, depending on the amount lent. Make sure you cover your bases with the right documentation and note the loan on your business tax returns the way you would any other loan if you want to avoid an audit, fines, or worse.
You won’t build business credit with your informal loans.
When you take on any kind of financing, from a credit card to a line of credit to a traditional term loan, you do yourself and your business a favor in the form of taking steps towards building your business credit. A business credit score is a little different from a personal FICO score, but the idea is the same: Your business history has a number that represents creditworthiness. And making payments on your debts regularly, on schedule, improves that number.
You won’t build business credit if your buddy loans you a few grand on a random Wednesday, even if you pay him back by the weekend. Consider using financing methods that help you build towards securing even better funding terms in the future.
Some lenders have unmatched rates and resources.
The truth is that while lots of short term business loans have high rates and quick repayment terms, the field of small business loans is proliferating and there are more lenders every day who are willing to extend more generous offers to new and established business owners.
Additionally, SBA loans—loans partially guaranteed by the Small Business Administration—are known for their excellent rates. Not only that, but the SBA has a vested interest in helping you succeed, especially once you take on loans via their programs, such as the 7(a) program or microloan program.
The SBA puts business owners in touch with mentors, advocates, and fellow business owners; connects them to seminars, groups, and conferences; and works with other organizations to provide as much help and insight to small business owners as possible.
While your friends and family might be happy to loan you money, they may not be willing to do so for the amounts and lengths of time that SBA loans offer (some upwards of $5 million, to be repaid over decades). Family or friends also may not have the experience or knowledge to help you succeed with their money that the SBA and other lenders can provide.
In conclusion, it’s understandable that a loan through an old friend or close family member would be intriguing for small business owners trying to get a leg up in the competitive, changing business landscape. But the pros are typically outweighed by the cons and don’t contribute to the overall health of your business, not to mention your personal relationships. Consider looking for a workable form of outside financing instead, and keep your family loans to covering things like dinner or the movies.