Why friends and family should not be your first option when trying to secure a reliable business loan.
Not too long ago Pepperdine University released their Private Capital Access Index for Q3 of 2013. Although I’ve mentioned this before, I wanted to address what I think is one of the biggest revelations of the report. If you’ve tried to secure a small business loan in the last few years, you know how difficult it can be. Of the top five sources of capital identified in the Pepperdine Report, most small business owners, 59 percent, put a visit to the bank at the top of their list of potential sources and friends and family at the bottom (44.2 percent). Ironically, when it comes time to actually visit the bank, 71 percent wind up securing financing from friends and family (the top of the list) and only 27 percent of those surveyed find funds at the bank (now the bottom of the list). In my opinion, 27 percent is pretty generous, I’ve also read a number of other surveys that put it somewhere around 10 percent.
Regardless, the lions share of small businesses seem to get the capital they need from friends and family—what many in the business call a Three-F loan—friends, family, and fools.
The Three-F loan is what my dad would call “skating on thin ice.” I don’t think anyone intends it to be this way, but the nature of family and friend relationships is often taken for granted and it’s easy to miss making payments. Sometimes Mom, Dad, or your rich uncle Fred will even start off the relationship with something like, “Don’t worry about making payments right now, as soon as your profitable—you can pay me back then.”
This is a bad way to get started, in my opinion. Unless you want to start avoiding family gatherings like Thanksgiving, Christmas, or the next big reunion. I don’t think anyone wants this to happen. Most Three-F loans start out because your dad or your wealthy college roommate wants to help. That doesn’t mean they don’t want to get paid back—unless they just gift you the cash. It goes to show securing a reliable business loan should not be a family endeavor.
My father-in-law had a great way he handled this. Although these weren’t business loans, I think his approach is relevant to this conversation. Whenever one of his children needed to borrow money, the transaction was added to a ledger he kept in the his home office. The amount, the borrower, and the agreed upon terms were all noted. If you borrowed money, you knew he was keeping track. Meeting the obligation (which required communication if there was a problem) bode well for getting a little cash in the future, ignoring those obligations made it more difficult. He treated the personal loans as just that—loans.
When borrowing from friends and family, I’m convinced you should treat those funds the same way you would treat any borrowed or equity capital. Create a formalized loan document that outlines all the details, including the terms of the loan if you’re treating it that way, or outline how much equity you’re willing to offer for money treated as an equity investment. I’m convinced this type of funding becomes problematic when one, or both, sides of the transaction take things too cavalierly and the agreement becomes misunderstood. Which is why they call it a Three-F loan in the first place.
What have you done to make sure you haven’t had problems when borrowing from friends and family?