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Getting Money From Family and Friends for a Business

You can finance your new business in many different ways: a bank business loan, angel investors, venture capital funding, or even crowdfunding. But if you've tapped out the traditional methods, including your savings, retirement accounts, and the equity in your home, obtaining money from family and friends is a great way to get or keep a business going.

It's common for small business owners to start up a business by using funds from lenders like family and friends. Borrowing money from family and friends or giving them an equity interest in the company is much easier than obtaining funding from a bank.

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Benefits of Borrowing Money From Family and Friends

Unlike a bank loan, acquiring private money does not require filling out paperwork or waiting for the loan to go through. Entrepreneurs who obtain financing from loved ones like friends and family gain several advantages.

  • Flexibility of a private loan: Unlike a standardized bank loan with inflexible terms, it's possible to work out a customized repayment schedule. For example, a generous family member or friend may allow interest-only payments for a short time. They may also delay initial repayments for several months so you can keep your cash flow in your business.
  • Credit history is irrelevant: It may be nearly impossible to acquire a loan when the borrower has a history of credit problems or bankruptcy. Many banks shy away from lending to borrowers with financial risks.
  • Lower interest rate: Banks establish interest rates on business loans by using the prime interest rate as a base and adding a few percentage points. The interest rate on a loan depends on the creditworthiness of the borrower and the economy. In most cases, the interest rate on money from family or friends will be much less than a standard bank loan.
  • Collateral is unnecessary: Because of the risk involved in lending money to a business, commercial lenders often require security for a small business loan, such as a mortgage on a property. Most friends and family won't require collateral to secure a private loan.

The amount of money you ask friends and family to lend you should be based on business decisions.

Asking for Money

Money is a touchy subject. Asking friends and family for business funding for a business endeavor can be uncomfortable. But if you believe strongly in the business idea and the possibility of its success and have a business plan, it's easier to get funding from loved ones.

Take these steps when planning to obtain financing:

  • Schedule a meeting
  • Provide information about the business
  • Offer a product sample or a brochure
  • Provide a business plan
  • Thoroughly explain the risk
  • Allow the friend or family member time to think
  • Formalize the arrangement in writing

The appropriate environment for your sales pitch will vary depending on how well you know the potential private lender. In a home, the appropriate places are the living room or kitchen table. In public, a coffee shop or a restaurant are common spots to ask about funding from friends and family loans.

Put the Terms of the Loan in Writing

The terms of the lending arrangement should be in writing. The loan agreement and promissory note should include:

  • Terms regarding the interest rate
  • Late fees
  • Repayment terms
  • Length of the loan

A written agreement establishes each party's legal obligations. It also defines the important terms of the arrangement and is considered legal documentation of the loan. This provides evidence to the Internal Revenue Service (IRS) that this was a loan and not a donation.

Offer an Equity Interest

Some friends and family might prefer an equity interest in the business. An equity investment gives the investor a share of the business. This means that the investor will share the profits and losses as a business co-owner. Unlike a loan, if the business fails, there's no obligation to pay the investor back. The investor, therefore, bears all risk unless there is a guarantee on the investment.

A business that operates as a sole proprietorship becomes a general partnership when an equity investor becomes a part of the business as a co-owner. General partners are subject to personal liability for the business's debts. To shield an equity investor from bearing more loss than the initial investment, consider converting the business to any of the following business structures if you offer an equity interest:

  • Corporation: The investor can become a shareholder. A shareholder who doesn't participate in running the business or in making decisions is free from liability beyond the investment.
  • Limited partnership: A limited partner not involved in running the business will not incur personal liability.
  • Limited liability company: An investor who becomes a member is shielded from liability for the business's debts unless the member engages in wrongful conduct.

Most investors are unprepared to risk more than they have invested, even if they have a personal relationship with a business owner.

Get Legal Help When You Need It Most

If you're considering financing from a friend or family member, you'll want a business law attorney on your side. A qualified attorney can help you negotiate important terms and ensure the agreement is in writing.

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