Chances are they’ve been your biggest cheerleaders as you’ve started and grown your small business. But should family and friends also bankroll your business?
Borrowing money from your parents, in-laws, or even your best friend from college may seem like an easy financial solution when capital is not forthcoming in those early days. But small business experts say this option can be more complicated—and emotionally messy—than it seems. “Most small business owners who go to family for money approach it like they’re about to borrow $20,” says Andrew Keyt, executive director of the Family Business Center at Loyola University Chicago. “The process is too informal and that increases the possibility of tension and misunderstandings with family members down the road.”
Despite those potential pitfalls, small business owners continue to seek out money from those near and dear. A business financing survey by the Global Entrepreneur Monitor, a research consortium that includes Babson College, showed that small businesses raised $41.6 billion in 2010 in so-called informal funds. According to the respondents, 32 percent said the money came from a friend or neighbor; 26 percent said from a close family member; 11 percent from some other relative; and eight percent from a work colleague.
Still, there are ways to borrow seed money from family and friends without making the next holiday gathering stressful and awkward for all involved. Below is some advice from small business experts on how to do it right.
Be clear, candid, and professional
If there’s one topic that people are uncomfortable discussing, it’s money. Talking about money to family only notches up the pain. So says Karen Axelton, co-founder of GrowBiz Media, a market research and consulting firm that helps corporations and government agencies connect with small and mid-size businesses. “Glossing over the details of how much you need and why, because it’s awkward to talk about money with your parents or siblings, is never a good idea,” she says.
Rather, treat the conversation as if you are having it with a stranger—or better yet—a banker. Arrange a time to speak that’s good for everyone and focus only on the issue at hand. Explain the amount of money you’re looking for, your plans for the funds, and how you intend to pay the money back and over what period of time.
It also helps to present potential lenders (yes, even mom and dad) with a detailed business plan. Says Keyt: “Even your closest relatives will want to know if the money is going to some half-baked idea or a business that has a chance to succeed.” Give them time to read it over—preferably without you looking over their shoulder, cautions Axelton. And above all else, Keyt advises, be clear. “Problems arise when both parties have unarticulated expectations. Leave as little as possible open to misunderstanding.”
Define the investment
Are you looking for a loan, equity investment, or an outright gift? Each has a different set of issues—and financial responsibilities—so making sure you define the terms is critical, says Axelton.
With a loan, you’ll want to determine the interest rate you’ll pay on the money you’re borrowing, the repayment period, and what you’ll use the money for. An accountant can draw up these forms, or you can find them through an organization such as SCORE, she says.
Unlike with a bank loan, when the money is coming from mom and dad or the in-laws there’s often wiggle room with the repayment schedule. Pretend there isn’t. Judy Barber, a family business consultant and mediator based in San Francisco, says even if family members don’t need the money repaid on time—or at all—changing the terms of a loan is never a good idea. “It annoys parents because it makes it look like their adult children aren’t taking them or the business seriously,” she says.
Money that comes in exchange for an equity investment is a bit more complicated and will require some soul-searching, say the experts. For instance, do you really want your business savvy father-in-law weighing in on expansion plans or questioning your social media strategy? “Those are the kinds of questions that entrepreneurs have to ask themselves if they’re taking money in exchange for a piece of their company,” says Keyt.
An equity investment also comes with a fiduciary responsibility to share financial data with investors, and in most cases, make them board members. “If you’re going this route, make it clear what percentage of the company they are getting in exchange for their investment and the liquidity options they have when they want to get their money out,” Keyt explains. Also make clear whether or not you’ll be paying dividends to these shareholders and if so, how often. And get professional guidance. Both Keyt and Axelton recommend using a lawyer to draft an equity investment agreement.
As for gifts, well, they too have to be handled with care. To begin with, says Barber, make sure everyone involved understands that the money is just that: a gift, with no expectation that it will be paid back. Further, be sure to stay on top of IRS gifting guidelines. For 2013, the amount of money someone can give as a gift, tax-free, is $14,000, up $1,000 from last year. And of course, the money is not considered taxable income for the recipient.
Put it in writing
Just because these are the people who love you most in the world, doesn’t mean you get to take short cuts when it comes to money. Put everything in writing. “Family and friends are naturally excited for you and optimistic about your chances for success,” says Axelton. Bring everyone back down to earth with a written document that makes clear the terms each party has agreed to, she advises. Enlisting the services of a lawyer is advisable, but not always needed when drafting this kind of agreement, but getting any contract or written agreement notarized is recommended.
It’s also a good idea to include in this document a list of the risks that the lender is taking on by loaning you the money or making an equity investment in your fledgling company. “Not every business succeeds and it’s up to the small business owner to lay out a worst-case-scenario plan,” she says. “What if the business fails and it takes you double the amount of time to repay a loan? Or you can’t repay it at all? You need to set down expectations in writing so everyone knows what the risks are.”
No, you don’t have to send out daily emails detailing the new client you just snagged or that you’ve hired your third employee. But when you see or speak with your family investors (and you will) give them a brief, honest assessment of how the business is doing and any highlights, say the experts. And of course, if there are dire problems that could impact your ability to start or continue repaying your loan, alert them to that sooner rather than later, says Barber.
In the end, borrowing from family and friends can be tricky, but when done right, it just might give you the money you need to start the next Subway or Walmart. After all, the founders of those companies borrowed money from their families to get their businesses off the ground, and no one could argue those weren’t good bets.