Banks, credit unions and other conventional business lenders have tightened credit in the past several years, and don’t seem to be loosening their grip anytime soon. As a result, small businesses fortunate enough to be in a position to expand are having trouble securing the money needed to do so and are looking at alternatives. One such alternative may be borrowing from a family member or friend. This is sometimes referred to as a social- or peer-to-peer loan.
According to SCORE, a non-profit association of retired executives and business owners who assist small businesses, investments by family and friends account for more than half of all investment dollars for startup businesses.
Of course, loyal family members and true friends might loan you money just because they want to see your business succeed. But let’s face it, with the low interest rates being paid out on bank CDs and money market funds, they might be willing to invest in hopes that your company will pay them a higher return on their money than they can get anywhere else.
Don’t just blurt out a loan request in the middle of Thanksgiving dinner or at your class reunion, however. Politely ask the potential lender if you can meet privately. Then prepare ahead of time what you are going to say. The first step in successfully borrowing money from friends or family is to assure them:
1. Their investment is smart financially.
2. Their investment won’t harm your personal relationship.
IT’S ALL IN THE DETAILS
If you introduce the topic of securing a loan from a friend or family member and get a positive response, plan to meet again to discuss it further. This time, take a list of details, including how much you want to borrow, any other sources you are using, the interest rate you’re offering to pay, your proposed repayment schedule, the legal and financial protections you’ll offer to the lender and how much you have available for the down payment for the item you are looking to finance.
Don’t pressure the potential lender, but be reassuring. Be realistic about how much money you want to borrow. Don’t base your request on how much you need, but how much an individual can afford. And don’t ask for more money than a person can afford to lose, even if it means asking several different people for loans.
GET IT IN WRITING
Treat whomever you approach for a loan like you would a bank. Be willing to show them a detailed business plan and put up some collateral. Show them your credit report and any other personal financial statements they might be interested in.
Once a friend or relative agrees to loan you money, proper documentation is essential. For one thing, it will ease your mind if you are worried that grandma will meddle in how you run your business after you borrow money from her. Formalizing the loan makes it clear that this is a loan, not a favor, and her role does not go beyond that of lender. Setting up a mutually agreed upon repayment plan lets her know you are serious about paying her back.
One more argument for proper documentation: Even if the uncle you approach for a loan slaps you on the back and says, “Aw’ shucks, sonny, just pay me back when you can,” and refuses to charge you interest, you should draw up a contract or promissory note for the loan because otherwise, the IRS can actually attach a rate to an interest-free loan for you, or decide that the loan was a gift, and either action will have tax consequences.
Yes, even if Uncle Fred trusts you, Uncle Sam might not. If you do not clearly document that money provided to you from a friend or relative is a loan by defining interest and payment terms and specifying the collateral, the IRS may mistake it for a gift or an inheritance and it could cut into your gift tax or estate tax exemption.
HELP IS AVAILABLE
If all this paperwork seems overwhelming, you may be relieved to know there are services that will prepare documents, create repayment schedules, process payments and provide year-end tax statements and do whatever else is needed to facilitate loan transactions between private parties. Using an outsourced loan service can go a long way toward reassuring family members or friends that borrowing money will not harm your relationship. If an outside company is managing the repayment processing and record keeping, for example, your lender won’t have to initiate an uncomfortable conversation that might put a strain on your relationship if, say, a payment is late.
Several online loan service companies match people wanting to lend money with people wanting to borrow money. A better first stop, however, if you are investigating loan service companies, is www.virginmoneyus.com because it focuses specifically in facilitating and managing loans between family and friends. In fact, Virgin Money was started by British industrialist Richard Branson, who, thanks to a loan from his aunt that got him started, founded Virgin Atlantic Airlines, Virgin Records and more than 300 other businesses. Now there’s a family and friends loan success story!
IF YOU ARE TURNED DOWN
The key to successfully borrowing money from a friend or family member — whether you are in the music business like Branson or the portable restroom business — is to be as honest and professional as possible.
If a bank turned you down, the mature, professional thing to do would be accept their reasons, revamp your presentation and take your request to another bank. So if a friend or relative refuses you, assume they have their reasons, and move on to Plan B. Maybe they’ve been burned in the past and have sworn off loaning money to friends. Maybe their spouse isn’t comfortable with the idea. Or maybe they just don’t have the resources you think they do. Whatever the reason, it’s not worth spoiling a relationship, so let it go and drink a toast to your business with them next Thanksgiving.
