Friends and family business loans, or financing from friends or family members remains one of the primary sources small businesses of every size use to access capital to fuel growth or otherwise fund specific initiatives. To make the most out of this type of capital and ensure that you continue to be invited to the family holiday parties, there are some important considerations and a few things you can do before you approach your father-in-law or old college roommate.
Is it a Loan or Are You Offering Equity?
You will need to determine whether or not you’re looking for a business loan or equity arrangement, and which makes the most sense to meet your capital needs.
If you choose to offer ownership equity in your business, your family member (acting as an investor) should be treated the same way you would treat any other equity investor, this means they will be exchanging capital for a percentage of ownership, or stake, in your business. This is different than a loan because your business doesn’t acquire additional debt, there are no periodic payments, and the investor is willing to wait until a future date to capture some kind of return on their investment.
If your family member chooses to invest in your business they may want to have some input into decisions you make about how your business grows and conducts business. Like any other equity investor (depending upon the percentage of ownership they have), you may need to consult with them before making important decisions, so you’ll want to make sure it’s someone you trust and are willing to have as a shareholder in your business. They may also want a way to exit their investment at some point in the future or earn some kind of dividend along the way.
If a loan makes more sense, you aren’t offering your friend a percentage of ownership equity but rather a periodic payment arrangement. This is a good option if you are able to make regular periodic payments and don’t want the complications of creating an equity agreement with one of your family or friends. It’s a good idea to determine how much interest you’ll pay, and how long it will take you to repay the loan. You should treat this the same way you would treat any other loan that requires repayment on a predetermined schedule.
Take Friends and Family Business Loans Seriously and Be Prepared, to Make the Most of this Capital
As you contemplate approaching someone close to you for capital, avoid the temptation to think your current relationship makes it possible for you to be cavalier about it. Of course there will be some emotions involved with asking a close family friend or a relative, but it could be even more important to demonstrate that you are serious and committed about your business, have a thoughtful business plan, and know exactly how you plan to use their investment to grow your business. Here are seven keys to help you get started:
- Identify what you need the extra capital for: Because we live in a world where popular media would suggest that capital is the solution to every small business woe, don’t be surprised if Uncle Fred is skeptical about your need for a little more cash flow. Your pitch will likely find more success if you have identified what you plan on doing with the money and the bottom-line impact it will add to your business. It’s also a good idea to share why you think the extra capital will help you achieve those goals and what the consequences might be without it.
- Know exactly what you need: I sometimes have the opportunity to speak with business owners seeking financing for their business and this is usually one of the first questions I ask. If they respond with, “As much as I can get,” I cringe. That is not the right answer. Like your old college buddy, I have more confidence in a business owner who knows exactly what he or she needs and asks for that—and no more. Your friends or family don’t want to feel like you’re treating them like some kind of ATM machine.
- Be prepared to speak with more than one person (depending upon your objectives): You may need to embrace the idea of involving more than one person to gather enough capital to reach your objectives. Not only will this spread out the risk for those investing in you and your company, it reduces you obligation to any one individual.
- Create a payment schedule: If you’re looking for a loan, a proposed payment schedule is a good thing to present when you ask. It demonstrates your intention to repay your family member. Include how you will address unforeseen challenges that might require you to miss a payment—how will you deal with that? What if your benefactor needs to be repaid sooner? Is that an option? Being proactive and contemplating how you will deal with these situations in advance will help you navigate those challenges if they occur. Your mom may say something like, “You can start paying us back as soon as you start making a profit.” I’d suggest you not leave it at that. If she really doesn’t expect you to start making repayment right away, determine when in the future it makes sense and agree to start making repayment in 12 months or whenever the two of you decide.
- Put your agreement in writing: My grandfather used to say, “Locks are for honest people.” In other words, putting your agreement in writing (regardless of whether it’s a loan or an equity agreement) will keep both you and your family member from making assumptions about what the agreement means. It’s important to define the conditions of your contract. A legal document that you both sign will ensure you’re both on the same page.
- Be prepared to take some advice: Because you are taking their investment (or a loan), they will likely feel they should have a say in how you run your business. Be prepared to treat them as you would any investor (or lender) and expect them to have an interest in how things are going.
- Be transparent: Because of their personal interest in you, they’re going to be interested in how your business is doing. Keeping them up to date on how things are going will allow them to see your progress, how their investment has impacted your business, and demonstrates to them that you’re not hiding anything from them. If they are investing, you will likely want to provide them with regular formal updates on how the business is doing (the frequency will be up to you and your investor).
Avoiding the temptation to be casual in an arrangement with a family member or friend might seem like overkill, but those who do avoid misunderstandings and have fewer conflicts. Friends and family business loans are one of the only ways very young small businesses are able to capitalize their companies, but many more mature businesses also turn to family or friends. Just remember to keep things professional and be aware that when you accept either a loan or an investment, your relationship will change and will include the addition of a business relationship.