When starting up a new business or making an investment, entrepreneurs may well find themselves turning to family members or friends for some much-needed funds. This is anything but uncommon; some of the most well-known companies in the country were founded using the capital of friends and family. Richard Branson received a loan from a generous aunt to start Virgin Records, Sam Walton founded Wal-Mart with funds lent by his father-in-law and Atlantic Records founder Ahmet Ertegun borrowed money from his family’s dentist. Friend and family loans can be an integral part of the entrepreneurship process. In fact, such loans are the second most popular source of start-up capital after self-funding, according to Entrepreneur.com.
But be warned: There can be a great many dangers along the way. Entrepreneurs who borrow money that they never repay could wind up forever destroying once-great friendships or creating devastating family feuds.
“There is the risk to the relationship,” Helen Payne Watt, director of content for Virgin Money, a company that manages loans between friends and family, said. “It’s a perception that a lot of people have. Their first gut reaction is, ‘Oh no, you shouldn’t do that!’”
Friends and family often offer lower interest than banks
Even so, loans from friends and family offer some substantial benefits. Rates are typically lower, terms tend to be more flexible and the approval process is significantly simpler than with traditional loans.
“When there are loans between individuals who know each other there’s no application process, there’s no filling out of forms, there’s no credit check. All that is done based on the relationship,” Watt said.
So how can eager entrepreneurs keep their personal relationships from going belly-up when borrowing start-up capital? Here are a few tips to consider:
Choose lenders carefully.
Some friends and family members may not be capable of offering “no strings attached” loans, and may consider someone's indebtedness to them as a free license to meddle with their business and their life. Any friends or family members who may have ulterior motives for helping an investor out should be left off the list, according to Entrepreneur.com. Additionally, it can be worthwhile to “think outside the box” when considering potential sources of capital, according to Expert Business Source, an online publication dedicated to small business issues. Parents, aunts and childhood friends are only a small portion of the potential lender pool. Consider extended relations and family acquaintances as well.
Present a solid, professional business plan.
“Much like explaining the business to an investor, a borrower should put together a short presentation for family and friends,” according to Expert Business Source. Although friends and family may not be interested in the same spiel as professional investors, it’s important to at least include the basics, such as goals and potential risks. This way, the relationship starts off professionally and potential lenders are fully aware of what they’re getting themselves into.
Accept rejection as part of the process.
Entrepreneurs shouldn’t let themselves get offended if family and friends are unwilling to hand over their hard-earned cash. Treating potential lenders professionally is a must, and this includes accepting rejection from those who aren’t interested in the venture. Entrepreneurs undoubtedly are not interested in being manipulated or guilt-tripped by the friends and family who lend them money, so they should show the same courtesy to those whom they solicit for funds.
Consider equity.
“One way to safeguard the relationship—at a cost—is to tie financing to equity rather than a loan,” according to Inc. magazine. It provides more leverage to friends and family who may offer their money to the business, but may put entrepreneurs in the uncomfortable position of having to dilute ownership in their own company. But investors may be left with little choice if they have exhausted other capital sources, according to Inc.
Structure the loan professionally.
Once a friend or family member has agreed to provide money for the business venture, outlining the loan terms and repayment plan in official documents can alleviate a lot of problems further down the road. “Setting down the terms of a loan in writing, and having both parties sign, significantly reduces the potential for a misunderstanding,” according to Expert Business Source. When structuring repayment plans, consider paying back the amount gradually as opposed to opting for a lump sum payment after a certain amount of time. Virgin Money offers different levels of loan management for friend and family loans, ranging from simply drawing up a promissory note to actively handling repayment via its website.
