Borrowing from Family or Friends

Almost everyone who thinks about starting their own small business has to confront the question of obtaining capital at one point or another. While some entrepreneurs may be able to use their small business financial software to work out a plan for self-financing their start-up, the majority will seek outside sources.

For some business owners, these sources may include family or friends. Particularly if you are starting your first company and do not have a proven track record and established cash flow, a loan from a family member or friend can make sense.

However, many business experts suggest only utilizing loved ones for funding as a last resort, after all other options have been explored. Before turning to friends or family, you might consider a peer-to-peer lender or simply having someone co-sign for a loan rather than giving money directly. Work through the various options using your small business finance software. Many entrepreneurs use a variety of funding sources.

Benefits of borrowing from family and friends

An already-established relationship. Your friends and family already know and trust you, making them more likely to have faith in your business idea as well. Just make sure you have a sound business plan in place to support this feeling of confidence before you ask for a loan.

Less red tape. It's always a good idea to have a written business plan to guide you when starting a new firm. But those who borrow from people they know are less likely to have their plans scrutinized with a fine-toothed comb than people who approach a loan officer at a bank. Your relatives are also unlikely to check your credit score or ask for collateral.

Low or no interest on the loan. Obviously, the precise terms of each loan may vary based on the relationship and situation, but it's fairly unlikely that someone close to you will demand a high interest rate for a business loan. In some cases, they may ask for no interest at all.

Disadvantages of borrowing from family and friends

Complicating personal relationships. Borrowing money from a loved one can be a delicate proposition, and in a worst-case scenario it could damage your relationship with that person. Make sure you both approach the deal professionally, with all potential dangers discussed and formal arrangements in place.

Who's in charge? With these types of loans, you run a higher risk of receiving unsolicited advice about your company from a relative of friend, who may began to behave as if they own the business. You may have to remind them that a loan has not bought them a stake in your firm. However, remember that if the investment is treated as equity—rather than as a loan—they technically do own part of your business.

Dealing with tax implications. You should consult your accountant about the potential tax implications of the loan before sealing the deal. If it is large enough, you may be taxed on the amount of interest paid. If you are not paying interest, the person lending you the money may be liable for the Federal Gift Tax. A professional can help guide you, and you can use your small business finance software to plan for any additional tax responsibilities.

Formalizing a loan agreement

Even if the money for your start-up is coming from your best friend or your grandma, sealing the deal requires more than just a handshake. When formalizing a loan from a family member or friend, it is important to address some basic questions:

Will the investment be equity or a loan? If the money is treated as equity, your friend or family member will own part of your business. If it is a loan, you will repay it within a set period of time, including interest.

What is the interest rate on the loan? Working together, set a reasonable interest rate for repaying the loan.

What is the payment schedule? Similarly, choose an acceptable time frame for repayment. Make sure you don't delay making payments simply because the loan is from someone you know.

What are the penalties for not paying on time or defaulting? You have to consider all potential outcomes, even the less attractive ones.

How will you pay them? This aspect doesn't have to be formally documented, but you may want to consider using a third-party payment system to make the transactions more professional and avoid potential awkward moments from face-to-face dealings.