The Basics of Borrowing From Friends and Family…

The following excerpt is from the staff of Entrepreneur Media’s book Finance Your Business. Buy it now from Amazon | Barnes & Noble | iTunes

Borrowing from friends and family makes sense. People with whom you have close relationships know you’re reliable and competent, so there should be no problem in asking for a loan, right?

Related: Buying a Business Through Seller Financing

While borrowing money from family and friends may seem an easy alternative to dealing with bankers, it can actually be a much more delicate situation and it’s important to be as disciplined as you would be in dealing with a professional investor.

Here are some basic rules:

Treat them as if they were strangers.

Forget for the moment that your investor is a friend or relative. Make it an “arm’s length” transaction, and insist on the same sort of legal documentation you’d prepare if they were a total stranger. Why? Because too many entrepreneurs borrow money from family and friends on an informal basis. The terms of the loan have been verbalized but not written down in a contract.

Check with a lawyer.

Lending money can be tricky for people who can’t view the transaction at arm’s length; if they don’t feel you’re running your business correctly, they might try to interfere. In some cases, you can’t prevent this even with a written contract, because many states guarantee voting rights to an individual who has invested money in a business. This can create a lot of hard feel­ings. Make sure to check with your attorney before accepting any loans from friends or family. So if it’s a loan, have your lawyer pre­pare an IOU (called a “promissory note”) for the friend or relative, and don’t offer less than a commercial interest rate.

Debt may actually be better than equity.

If someone lends you money, you only have to pay it back, with interest. They can’t tell you how to run your company. If someone buys stock in your busi­ness, they are legally your business partner. When in doubt, make it a loan, and pay it back as soon as you can.

Tie all payments to your cash flow.

Try to avoid obligations with fixed repayment schedules. Consider instead “cash flow” obli­gations, in which your investor will receive a percentage of your operating cash flow (if any) until they’ve either been repaid in full with interest or achieved a specified percentage return on their investment.

Consider nonvoting stock.

If your friend or family member insists on buying stock in your company, try to make it nonvoting stock, so they can’t second-guess your every decision.

If one or a few of your friends and relatives have business savvy, great. Bringing them on as investors transforms them into motivated advisors. Plus, they’ll likely be more forgiving than outside investors when it comes to your business’s ups and downs.

Related: The Ins and Outs of Microfinancing Your Small Business

Raising money from your personal network can also be a step toward securing money from future investors, because it demonstrates you’re grounded in a network of family and acquaintances who’ve already bought into the business plan.

Of course, you risk losing friends and straining relationships with relatives. Your next holiday party won’t be as fun if half the people there think you fleeced them or are annoyed because you went on vacation before paying them back. That’s why it is best not to get too informal about the business relationship. Be upfront about risks, lay out the business plan that their money will fund, and put the rules behind the investment in writing.

It could be a gift, a loan or an equity investment in the business. Each has pluses and minuses, and each should be recorded in writing, in many cases a legal document.

Gifts.

The best thing about a gift is that you don’t have to pay it back. But you probably won’t raise as much as you would if you were offering a potential return on the money. Also, gifts can quick­ly turn into loans in the minds of friends and relatives should you succeed. A signed document — even a letter saying the money was given — will protect you down the road.

Loans.

Many experts suggest loans as the optimal way for friends and family to invest because there are set repayment terms. They’ll know how long it will take for them to get their money back and at what interest rate. (If you’re current with repayments, you can also avoid drawing their ire should you spend money on yourself.) A business attorney can easily draw up a promissory note detailing the terms of the loan. An SBA blog entry suggests another strategy to formalize the relationship: structuring the loan through a peer-to-peer lending company that will act as an intermediary, collecting the payments from you for a fee. Of course, one downside of borrowing is that you’re tying up some of your business’s cash flow in the repayments.

Equity.

You don’t have to pay them until you make a profit or cash out, but you’re literally turning a friend or a relative into a business partner if you give them an ownership stake in the company. You’ll want a business lawyer involved in this. Consider whether you want this person as a business partner. They’ll have a right to tell you how to run the venture. This can be highly beneficial if your acquaintance/investor has entrepreneurial experience or other useful know-how, but it can quickly become an annoyance other­wise. You also risk straining the relationship should you move on to another venture.

Related: Busting the 5 Myths About Small Business Lending

It’s always advisable to present a formal business plan when pitching to prospective investors — even friends and relatives. But you don’t need to present printed materials and charts upfront. Rather, it’s best to lay out your business plans verbally, because those in your personal network will likely base their decision on trust. The “kitchen table pitch” is really about selling yourself. Be frank about the risks, and explain what the money will go toward and how it will grow the business. Then follow up with written materials later.

It also helps to follow a basic Startup 101 rule and tap your own personal finances first before turning to others. Not only do you show that you have a great deal of skin in the game, but you’ll also have an easier pitch to make because you’ll have at least a kernel of a business going.

Finally, be prepared for some tough love. Especially if it’s a friend or relative who knows something about starting or running a business, their point of view may be just what you need.