Getting Money from Family and Friends for a Business
If you have tapped out 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 is common for small business owners to start up a business by using funds from family and friends. Borrowing money from family and friends or giving them an equity interest in the business is much easier than obtaining funding from a bank.
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. Obtaining financing from friends and family offers several advantages.
- Flexibility of a private loan: Unlike a standardized bank loan with inflexible terms, it is possible to work out a customized repayment plan. For example, a generous family member or friend may allow for interest-only payments for a short time or may delay initial payments for several months.
- Credit history is not relevant: It may be nearly impossible to acquire a loan when the borrower has a history of credit problems or a bankruptcy. Many banks will shy away from lending to a borrower that poses a financial risk.
- Lower interest rate: Banks establish interest rates on business loans by using the prime interest rate as a base and then add 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 for a business, commercial lenders will often require security for the loan, such as a mortgage on a property. Most friends and family will not usually require collateral to secure a private loan.
Asking for Money
Asking friends and family for money for a business endeavor can be uncomfortable. Money is a touchy subject, but if you believe strongly in the business and the possibility of its success, it will be a lot easier to sell friends and family on the idea.
Depending on how well you know the potential private lender will determine the appropriate environment for making your sales pitch. In the living room or at the kitchen table in a home, in a coffee shop, or at a restaurant are all appropriate places. 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
Put the Terms of the Loan in Writing
The terms of the lending arrangement should be in writing. An arrangement should include the terms regarding the interest rate, late fees, repayment terms, and the length of the loan. A written agreement establishes the legal obligations of each party and defines the important terms of the arrangement.
Offer an Equity Interest
Some friends and family might prefer an equity interest in the business. An equity investment will give the investor a share of the business. This means that the investor will share the profits and losses as a co-owner of the business. Unlike a loan, if the business fails there is no obligation to pay the investor back. The investor, therefore, bears all risk, unless there is a guarantee on the investment.
Most investors are unprepared to risk more than they have invested. 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 debts of the business. 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 that does not participate in running the business or in making decisions is free from liability beyond the investment.
- Limited partnership: A limited partner that is not involved in running the business will not incur personal liability for the business.
- Limited liability company: An investor that becomes a member is shielded from liability for the debts of the business, unless the member engaged in wrongful conduct.