Three-F Loans

Friends and family might not be the most popular place for small business owners to look for financing, but it is one of the most popular places to find it. Pepperdine University puts out a quarterly Private Capital Access Index every quarter, and a few months ago reported that of the top five places small business owners looked for capital, friends and family was at the bottom of the list. It’s interesting to know that where they find it is a completely different story. At the top of that list, where small business owners actually find capital (71 percent), is friends and family.

Although your generous Uncle Fred is a legitimate source of money, depending upon how the two of you handle the transaction can become problematic. 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 like Thanksgiving and Christmas.

My father-in-law had a great approach to how he handled loans of different types to his children. He didn’t require a formal loan document, but every loan was kept in “the ledger” with payments logged and balances tracked. He wanted to help his children if they ever needed it, but he wanted to make sure they knew his generosity wasn’t to be taken for granted.

Treating a small business loan from Uncle Fred, your father-in-law, or your former college roommate should be treated the same way as any other type of loan or capital acquisition. “Don’t worry about paying me until your profitable,” is a very kind sentiment, but has the potential to become problematic as months turn into years and you forget about the loan from Uncle Fred. I suggest you formalize the arrangement.

1. Are you offering equity for their cash? If so, formalize how much equity Fred gets for his “investment.” Yes, this means you just took on a junior partner, and Fred should be treated that way if you want to attend family gatherings without looking over your shoulder. This also means that you will likely need to plan on giving Fred a return or buying out his investment at some point. He’ll likely be satisfied if you’ve come to formal terms and he is treated like the investor he is. My dad always used to say, “Locks are for honest people.” Formal agreements like this should be looked at the same way.
2. Is it a loan? If so, the bank and any other lender would expect regular and appropriate payments. Even if your dad is willing to give you a no interest loan, formalize the payment schedule and treat it like a loan. “Dad, can I have a loan is a lot different than Dad will you give me some money?” Many parents are willing to “gift” money to help their children 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. My father-in-law was famous for taking small payments on loans, he just wanted to see something on a regular basis for money he “loaned.” He also was known to occasionally “gift” money to his children. It’s important to make the distinction.

Loans from friends and family have 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 and family. Who knows, you may need to go back to that well again.

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