08/ 18/ 2005
by Glenn Townes
It’s no secret that most traditional banks and lending institutions aren’t keen on loaning amounts smaller than $30,000 to anyone, especially to someone who wants to start a small business. According to figures from the Small Business Administration and California’s Greenlining Institute, more than half of all U.S. small businesses are started with funds from friends and relatives, while others are financed by depleting savings and maxing out credit cards. By some estimates, about 10 million people across the country have private loans from people they know.
When you borrow, you rely solely on debt financing. As with any loan, there are a multitude of risks and, perhaps, even some rewards for entrepreneurs, some lending industry experts say. Borrowing from family and friends can provide ready cash, easier terms, a longer repayment period and probably a smaller to nonexistent interest rate. If you do not repay the loan within a reasonable amount of time, you could lose the trust of family and friends. If you completely default on the repaying the loan, you could run the risk of straining relationships, eliminating family ties and even bringing on a lawsuit.
Here are some helpful tips to avoid common pitfalls that can occur when borrowing from family and friends:
1) Establish a formal meeting. Present a well-thought-out and carefully organized business plan or proposal.
2) Put everything in writing in a promissory note. You don’t need an attorney to do this, but it might be a good idea to seek professional and free legal advice. Every detail of the loan should be addressed and discussed. This includes a payment schedule; what happens if the business is sold; how the lender will be kept abreast of the business’s progress and its losses and profits; what new initiatives, marketing strategies or products are being implemented to grow and expand the business.
By carefully and meticulously memorializing the terms of the business loan, friends and relatives who invest in your business will be less apprehensive and opine about how their money is being used, as long as you keep them updated on business activities. Remember that how you handle the terms of a private loan may prove beneficial in the future should you apply for a traditional bank loan. Two useful web sites where you can view and download standard promissory notes are Judge Joe Brown and Net Identity.
Finally, have a contingency and an alternate plan in place. Prepare for the worst-case scenario, including bankruptcy, embezzlement or even death. For instance, you could add life and disability insurance to the original agreement. Perhaps make the lender the beneficiary; this would guarantee repayment of the loan in the event of your untimely death. Some small business organizations and advocacy groups offer a service to its members in which the group acts as an intermediary between business owners and their family and friends. For example, Circle Lending offers this service, making the formal proposal and drawing up the promissory note with interest. Depending upon what is agreed to and the repayment plan and schedule, the interest rate on the loan can range between 0 percent and 5 percent. The monthly payment can be deducted from a business checking account.
According to Circle Lending, the default rate of business owners who work with a mediator and develop a structured interpersonal loan is only 5 percent compared to 14 percent for those who rely on an old-fashioned handshake and pat on the back.
While some may contend that borrowing from family and friends to start your business is not the best choice, it’s indeed an option to consider. By implementing proper business etiquette and using some of the above suggestions, you can make business financing from family and friends less tenuous and stressful. It can be a viable option and a formidable step to entrepreneurship.
