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In a perfect world, small business owners would stick to borrowing professional money and avoid going into debt with family and friends to fund an unproven venture.
It’s not a perfect world. While it’s true that entrepreneurs have more financing options than ever before, startups often discover that traditional bank loans are out of reach, while online lending can be prohibitively expensive.
What’s an ambitious entrepreneur to do?
Related: Hard Truths and Tips about Borrowing from Friends and Family
I got my start in small business with a $15,000 loan from my father to buy a boom truck for my sign business. I had no other option — I didn’t qualify for a traditional bank loan, and my complete lack of credit history meant that every door I tried was closed in my face.
Perhaps you can relate. If you’ve tried all your other options, family and friends might be the only place to turn. After all, they’re invested in your success on an emotional level that no other lender can match.
I personally believe that these emotional attachments are sacred. A financial investment motivated primarily by love is a wonderful thing.
But if they’re sacred, they’re also fragile. Think long and hard before you test them by bringing money into the question. A valued colleague of mine suggests that entrepreneurs seeking financing from friends and family should always begin with the premise that their relationships are more important than their business.
That’s sound advice. If you follow it, and still conclude that borrowing from loved ones is the best way to go, here are some tips on how to best go about it:
1. Be brutally honest.
More small businesses fail than succeed. Talented people with great ideas fail every single day. While your family and friends might acknowledge that this is true of other people, love’s tendency to exaggerate strengths and downplay weaknesses can blind them to the possibility of failure in you.
Open their eyes. Make them see that investing in your business carries a significant amount of risk. If your business does end up failing, you’ll feel better knowing that you were perfectly clear about the possibility from the start.
Related: 10 Questions to Ask Before Applying for a Small Business Loan
2. Only borrow from those who can afford it.
This is a no-brainer. Never borrow money from someone who can’t afford to lend it. Even if they’re eager to help — even if they try to press it on you — turn it down.
Resist the temptation to rationalize that you can’t really know the state of their finances. You do. Thank them for their kind offer, and move on. It’s hard enough to lose someone else’s money, but to do it when they couldn’t afford it in the first place will lead to many a sleepless night.
3. Decide how much money you need.
Treat an investment from a loved one the same way you’d treat an investment from a traditional lender. Calculate exactly how much money you need, as well as what you can realistically pay back.
You wouldn’t ballpark a figure with a bank; treat your family and friends with the same respect. Build their confidence in you by showing that you are a cautious, meticulous borrower. Take it as a basic rule that the less you have to pay back, the better.
Related: Busting the 5 Myths about Small Business Lending
4. Consider a loan versus an investment.
Your family and friends may be excited by the idea of buying into your company, but you should give careful thought to taking their money as a loan instead. They may have dreams of turning thousands of dollars into millions, but you should temper those.
Explain that treating their money as a loan to be repaid with interest is a dependable way of looking out for everybody’s best interests. Explain that even if your business succeeds, their money will be tied up in it with no easy way to cash out.
On the other hand, if you borrow and repay the money, you get all the benefits of the loan and they get all the satisfaction of having helped you without being a penny the poorer for it. If your company does really well, they can always buy in at a later date.
5. Get it all in writing.
Forget about handshakes and verbal promises. Get the precise terms of your agreement down on paper. Whether it’s an equity investment or a loan, be painstaking about spelling out the exact nature of the terms.
Soliciting the help of an attorney isn’t a bad idea, either. Crafting your agreement under the guidance of an expert is an excellent way to avoid misunderstandings later. Remember my colleague’s advice: Your relationships are more important than your business. Cut no corners, spare no expense when it comes to protecting them.
My dad’s investment in my sign business helped me dramatically grow my business at a crucial time. Repaying him promptly filled me with satisfaction and him with pride. Though borrowing from loved ones isn’t highly recommended, it can be awesome if it works.
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