In the current environment, with tight credit, securing start-up capital drives many entrepreneurs to turn to alternative sources. Traditionally friends and family have been an invaluable source of support for the aspiring small business owner. That applies to financial support as well.
In fact, more small businesses rely on loans from friends and family than any other funding source. Having a personal relationship with the entrepreneur and his/her business goals, inside knowledge about the investment opportunity, and ready access to information about the venture’s progress are among the major reasons why friends and family members willingly contribute to a start-up or expansion.
As Mark Goodman, SCORE counselor from Chicago, explains in the short video interview below, the current tight credit environment has caused many small business start-ups to return to the way start-ups were financed decades ago – with family funds.
Still, a note of caution is in order. When the ready source of cash comes from family it is not without its potential pitfalls. Business loans from family and friends can cause a severe strain on relationships if they are not handled correctly. So often loans among family members are unstructured or loosely structured leading to financing and payback terms that haunt both sides later on. All too often, the specifics are forgotten, resulting in differing accounts as to the specifics. Unfortunately, research indicates that 14 percent of business loans from family and friends go into default compared to about one percent for bank loans.
To increase the odds of success, always approach family and friends with a detailed proposal, including a professional business plan with financial projections for your business, just as you would a bank or venture capitalist. Be frank about the risks. If things go badly, they could lose all or some of their money. Consider the consequences to your relationships of a soured business deal.
Choose a financing structure that works best for your business and make certain everyone understands it. Specifically, be clear on whether the deal involves an ownership stake in your business, or whether it is a simple debt you plan to repay. And be clear about repayment terms.
The upside of offering friends or family members a stake in the business is that your start-up will not be saddled with debt that must be repaid (lower overhead). The downside is that you will have to share the profits with your shareholders. Structuring a loan means you are not required to share profits but you will have to repay the loan based upon the terms to which all parties have agreed.
It is nothing more than a myth that because the funds are coming from family and friends, it can be done with only a handshake (“a gentleman’s agreement” as they say in the south). These types of handshake deals open the door for misunderstandings and hard feelings. And, if there is any group of people with whom you should avoid having misunderstandings and hard feelings, it is friends and family.
Documenting the terms of your agreement in a proper legal format is crucial. You can find downloadable legal documents, including many different Promissory Note variations, at www.findforms.com. Legal publisher Nolo and LegalZoom also offers loan forms and related information at www.nolo.com and www.legalzoom.com respectively.
Virgin Money is also another helpful resource. Details can be found at www.virginmoneyus.com, previously known as CircleLending.com before it was acquired by well-known entrepreneur Richard Branson. Virgin Money helps small business owners avoid the problems that arise with loans from friends and family by providing loan administration, recordkeeping, payment processing and structural support. The service emphasizes flexibility to meet the needs and concerns of both borrowers and lenders, from terms and interest rates to repayment strategies.
To learn more about financial issues facing your small business, contact SCORE by visiting the SCORE Website where you can ask questions or request free face to face counseling and or mentoring.
If you would like to contact me, you can do so by emailing me at mike.clough@bestbizpractices.org or visiting my LinkedIn page.
Posted by: Mike Clough
