There are many different ways that you can finance your new business: a bank loan, venture capital financing, or even crowdfunding. But if you’ve exhausted traditional methods, including your savings, retirement accounts, and equity in your home, getting money from your family and friends is a great way to get or keep a business going.
It is common for small business owners to start a business using funds from family and friends. It is much easier to borrow money from family and friends or give them an equity interest in the business than it is to obtain financing 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 pass. 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 create a personalized payment plan. For example, a generous family member or friend may allow interest-only payments for a short time or may delay initial payments for several months.
- Credit history is not relevant: It can be nearly impossible to acquire a loan when the borrower has a history of credit problems or bankruptcy. Many banks avoid lending to a borrower who poses a financial risk.
- Lower interest rate: Banks set the interest rates on business loans using the base interest rate as a basis 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 lower than a standard bank loan.
- The guarantee is unnecessary: Because of the risk involved in lending money for a business, commercial lenders often require collateral for the loan, such as a mortgage on a property. Most friends and family generally do not require collateral to secure a private loan.
How to request money as a family loan
Asking friends and family for money for a business can be uncomfortable. Money is a sensitive subject, but if you believe strongly in the business and the possibility of its success, it will be much easier to sell friends and family on the idea.
Depending on how well you know the potential private lender will determine the appropriate environment to make your sales pitch. In the living room or on the kitchen table of a house, in a cafeteria or in 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 brochure;
- Provide a business plan;
- Explain the risk in detail;
- Allow the friend or family member time to think;
- Make the agreement in writing.
Put the loan terms in writing
The conditions of the loan agreement must be in writing. An arrangement should include terms regarding the interest rate, late fees, repayment terms, and the length of the loan. A written agreement sets out the legal obligations of each party and defines the important terms of the agreement.
Offer of participation in the capital
Some friends and family may prefer a stake in the business. An equity investment will give the investor a piece of the business. This means that the investor will share in the profits and losses as a co-owner of the company. Unlike a loan, if the business fails there is no obligation to pay the investor. Therefore, the investor assumes all risks, unless there is a guarantee on the investment.
Most investors are not prepared to risk more than they have invested. A business that operates as a sole proprietor becomes a general partnership when an equity investor becomes part of the business as a joint owner. General partners are subject to personal liability for company debts.
To protect an equity investor from suffering more losses than the initial investment, consider converting the business to any of the following business structures if you offer a share of equity:
- Corporation: The investor can become a shareholder. A shareholder who does not participate in the management of the company or in decision-making is exempt from liability beyond the investment.
- Limited partnership: A limited partnership who is not involved in running the business will not incur personal liability for the business.
- Limited Liability Company: An investor who becomes a member is protected from liability for business debts, unless the member has engaged in unlawful conduct.