Borrowing From Friends and Family to Start a Small Business?

From the lender perspective, start-ups are a tough group. An entrepreneur with a great credit rating and another source of income can often get a loan, but when so few start-ups live through their fifth birthday, most lenders are reluctant to stick their neck out on a new business with no revenue, no collateral, and a business owner with a less-than-perfect credit score. Which is one reason, aside from dipping into personal savings, a loan from a friend or family members is a very popular way to get a new enterprise off the ground.

Although your generous Uncle Fred is a legitimate source of money, depending upon how the two of you handle the transaction could color your future relationship. There’s a reason these are often called Three-F loans (friends, family, and fools). If not taken seriously, these loans often become the catalyst for awkward family gatherings.

I’m convinced you should treat a loan from a friend or family member the same way you would treat any other type of loan. Granted, your father-in-law might protest with something like, “Just pay me back when your new business is profitable.” A kind and generous sentiment to be sure, but it has the potential to become problematic down the road. I suggest you formalize the arrangement—of course there are some decisions you’ll need to make:

1. Are you offering equity of cash? If so, formalize how much equity their “investment” is worth. Yes, this means you just took a junior partner, and you’ll need to treat him or her that way if you want to attend family or other social gatherings in the future without looking over your shoulder. You may be able to put off giving him or her a return in the short run, but like any other equity stakeholder, they’ll be expecting some kind of return once your business becomes profitable. He or she will likely be satisfied if you come to formal terms the same way you would any other investor—because that is their status. My dad always used to say, “Locks are for honest people.” Formal agreements are very much the same. They keep honest people honest. It’s easy to give 10 percent of nothing away, but down the road when that 10 percent is worth a couple million dollars it can be a little more difficult.
2. Is it a loan? If so, the bank or any other lender would expect regular payments. Even if you dad is willing to give you a no-interest loan, formalize the payment schedule and treat it the same way you would a loan from anywhere else. There are numerous amortization schedules online that will allow you to convert your agreed upon terms into a payment schedule. “Dad, can I have a loan?” is a lot different from “Dad, will you give me some money?” Many parents are willing to “gift” money to their children to help them get on their feet, but if they thought it was a “loan” and you thought it was a “gift” there’s a big potential for problems. Most parents are willing to take smaller-than-average loan payments over longer-than-average terms if they see regular and consistent payments. It’s never a good idea to take advantage of the good will of your parents, friends, or other family members. It eventually ends up costing you in the end.

Although they are one of the most popular ways a start-up entrepreneur finds cash to get his feet off the ground, it also has a huge potential for creating strife in a family. The easiest way to avoid the strife is to treat them seriously and avoid becoming cavalier with the generosity of your friends or family. Who knows, you may need to go back to the well again someday.

If you’re interested in seeing if you have any options for a small business loan, even if you’re a start-up, check out Lendio. Answer a few questions and we’ll match you to the best loan options.

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