- Terms are determined by the parties involved
- Should be documented with a formal agreement
- May include debt or equity financing
- An option for startups with no credit history
There are many options when it comes to finding a trustworthy source of financing for your small business. If you choose to ask friends and/or family members for loans, it’s crucial that you do so with a full understanding of the benefits and potential pitfalls of this type of financing. This will help avoid sticky situations and financial problems down the line.
Before You Ask
Before seeking financial help from your friends or family, you may need to face the emotions that often accompany asking the people closest to you for money. To have an effective outcome, you’ll want to be prepared to show that you are committed to your business, and have a well-thought-out plan to reach success.
Here’s what you’ll need to accomplish this goal:
- Present your business pitch. Even though you are talking to a friend or relative, you will want to treat them with the respect you would any other lender. Let them know you are serious. Present them with your vision to turn their funds into profit. Explaining your business strategy will ultimately demonstrate how you plan to profit.
- Ask for the right amount of money. Asking for a large amount might feel uncomfortable, but if it’s what you need, you will not succeed if you don’t have enough. When determining the amount, consider all the factors that go into starting or running your business, and be realistic about the following:
- How much money do you need to implement your ideas?
- How much money do you need to keep the business going? Don’t forget you will need money to pay employees, buy inventory, and keep the lights on.
- How much money do you need for yourself? Your salary should not be an afterthought.
- If you don’t feel comfortable asking one person for the amount you need, try asking multiple people for smaller sums. This will reduce your obligation to any single person.
- Create a prearranged payment schedule (and put it in writing). Include a separate section of possible scenarios as well. For instance, what if you can’t make a payment? Or what if your lender needs money sooner? If problems like these arise, you want to have the answers all laid out in advance.
- Sign a formal agreement. It is important that you and your friend or family member (now an investor), define all the conditions of your contract. A legal document you both agree on and sign will get rid of any confusion and ensure you’re both on the same page.
- Take financial suggestions along with the financial assistance. Since your family member or friend is handing over his or her money, and potentially investing in your business, they might want to have a say in how things are done – it is their cash at stake after all. So expect them to check in and offer their opinions.
- Be open with your finances. Make sure to establish an open and honest business relationship. Keeping your lender up to date with your business’ financial history (Profit/Loss Statements, TAX ID, etc.) will let them see the progress of your company and show them that you are not hiding anything.
Creating a Formal Agreement
The formal agreement can be an important part of making sure friends and family know you’re not trying to take advantage of their good nature. Even though you are dealing with someone you know, don’t be too casual about the transaction. An informal exchange might feel natural but can be a recipe for further complications.
When you agree to take the loan, put everything down on paper. Include the payment schedule, the “what if” scenarios, and any other conditions. You should always consult a lawyer for larger agreements.
Remember: writing everything down will help you avoid any misunderstandings about the loan, and will allow you to separate your business dealings from your personal relationship.
Debt Vs. Equity Financing
When you agree to accept money from a family member or friend, there will be options for how you structure the transaction. You will have to determine if the loan will be debt or equity financing.
With equity financing, your lender will become an “angel investor” and own a stake in your business. This is less risky than a loan because you don’t acquire debt, and you don’t have to pay it back if you don’t profit. It can be a good option if you know you can’t afford to take on the debt.
If your family member or friend chooses to become an angel investor, this means they have faith in your business. It also means they will become partial owners of the business and will probably want some kind of voice in how you run your business. You may even need to consult with them before making important decisions—so make sure it is someone you trust and are willing to have as a partner. They may also want a way to “exit” their investment at some point, or at least earn along the way.
Debt financing is another option. In this case your friend or family member will simply lend you the money and you will take on the debt. This is a good option if you can afford the loan payments and don’t want the complications of creating a “partnership” with one of your family members or friends. You’ll have to determine how much interest you’ll pay, and how long it will take you to pay back the loan. You should treat this the same as any other loan that will have to be paid back on a predetermined schedule.
To Sum Up
Getting financial assistance from a family member or friend can be a great way to start/expand your business, maintain your business activities, and provide the comfort of knowing that your investor is someone you trust. Just remember to keep the dealings professional, and be ready to show you are prepared to make regular and timely payments. When you accept the loan, your relationship will shift to a business relationship, and you should treat it as such.