According to the Pepperdine Graziadio School of Business Management’s most recent Private Capital Access Index for Q1 of 2015, small business financing success rates for loans from friends or family remain very high for business owners seeking financing. 68 percent of the business owners surveyed who sought funding from a friend or family member found success. And lest you think it’s only the smallest businesses in the survey finding success there, those businesses with revenues less that $5 million were at the average while bigger small businesses, those with revenues from $5 million to $100 million, saw the success rate jump to 89 percent.
In other words, small businesses continue to find success from family and friends when looking for capital.
While many business owners find success with friends or family, those business loans present some challenges more traditional financing does not. For example, how does a business owner borrower from a family member and still feel welcome at the family reunion or Thanksgiving dinner? Or, is it possible to borrow from a friend and still attend the next class reunion? After all, borrowing money for your business isn’t the same thing as borrowing the Buick for prom night or your roommate’s history textbook.
My father used to say that locks and contracts are for honest people. Putting the terms of a friends and family loan in writing will help both parties avoid misunderstandings and help ensure your friend or family member feels good about offering your business a loan. With that in mind, here are four things you should consider including in a loan agreement:
- How much money you are borrowing and its purpose: In addition to knowing how much you want to borrow, most lenders will also want to understand the loan purpose, and a private lender like your father or your old college roommate, deserves the same disclosure.
- Formally structure the payment terms: Even if Uncle Fred is willing to defer payments for a while, it makes sense to establish when those payments will begin, how much the payments will be, and how frequently you will make them. If you have questions about how to construct the loan agreement, your accountant should be able to help you structure the loan document(s). In fact, it’s not a bad idea to consult with your accountant to put together even a simple agreement.
- Include the interest rate: Even if your friend is willing to give you an interest-free loan, there are limits to how much they can lend you that way. On anything over $100,000, the IRS will tax them as if they were being paid a “fair market” interest rate. It might be much better for your friend to charge you an interest rate—and unless the interest is stipulated in the loan documents, you won’t be able to deduct the interest payments from your taxes.
- Identify what happens if you can’t make the payments: What are you going to do if you miss a payment? Can you defer for a month? Will you pay additional interest? What happens if you default? Are you willing to offer collateral?
Additionally, putting the agreement in writing will most likely make life easier for both of you at tax time. For starters, a formal agreement shows the IRS the money was not a gift. If the IRS views it as a gift it becomes subject to gift tax rules and your lender will need to pay taxes on anything over $13,000.
Approaching a small business loan from a friend or family member with a formal document ensures that everyone understands the terms and helps eliminate the possibility of misunderstanding. It also helps avoid the temptation to take advantage and ignore the obligation to repay the loan. There’s a reason these loans are sometimes referred to as 3-F loans (Friends, Family, and Fools). It’s easy to make bad decisions in the heat of battle. Making some of these decisions ahead of time helps avoid those potentially awkward moments over the pumpkin pie.