When he started up his company several years ago, Alan borrowed $25,000 from his brother-in-law. He's since paid off the loan completely. Everything went fine. The two men remain close. So would Alan do it again?
“Never in a million years," he told me.
For Alan (who asked me to change his name for the purposes of this piece), and many other clients I know, borrowing from friends and family isn't always what it's cracked up to be. Of course, it's a very popular form of financing. A 2014 survey from The Hartford of more than 2,000 small-business owners across the U.S. found that more than 36 percent of small-business owners used personal sources of funding, such as personal savings, retirement savings or capital from their family and friends, instead of traditional sources of funding such as bank loans, bank credit lines or Small Business Administration loans.
To understand why getting financing from personal resources and family members is a popular choice among small-business owners, it may help to understand that getting money from traditional banks may be difficult for some small companies.
A business transaction between two family members may become everyone's business.
There may be benefits to borrowing from family. That's why Alan turned to his brother-in-law. Alan's startup, a small manufacturer of high tech equipment, required $50,000. He only had half that amount saved. No bank he tried would talk to him. And his brother-in-law was willing to help. It was easier. Alan wasn't forced to go through the due diligence that a bank or other financier might require. The interest rate he paid was reasonable. There were no minimum reporting requirements or other covenants like maintaining a certain debt-to-equity or debt service ratios. He wasn't asked to deliver a financial statement from an accountant. He didn't have to put up collateral. And all the time, if something went wrong, Alan knew that his brother-in-law would be more flexible with repayment than a financial institution.
And, fortunately, nothing did go wrong. Alan's startup grew and he was able to pay back the loan in just a few years. And he's grateful that his brother-in-law was there to help. So why would he never do it again?
“There were intangible costs," he said to me recently. “And for me, these costs were higher than the benefits."
By intangible, Alan means the cost of his relationship. From the moment his brother-in-law lent him the money, Alan sensed a noticeable change in the family dynamic. Money may affect relationships.
“I found there to be something unsaid in the room whenever I saw him and my sister," said Alan. “It was as if they were a little superior, and a little anxious at the same time. Happily, it all worked out." And this was a situation where everything turned out fine.
Imagine if Alan was late with a payment, or he couldn't pay back the money at all. It's one thing to renegotiate a loan or work out a payment plan with a faceless financial institution that does this kind of thing every day. It's quite another experience to have to do the same with a family member that you're going to see every other weekend. Not being able to pay back money may put everyone in an awkward situation. And, like most families, it's not just about the lender and the borrower. It becomes a family story. Besides his sister and parents, Alan has two other siblings and they have in-laws and nieces and nephews and cousins. A business transaction between two family members may become everyone's business, particularly if things go south.
And yet, the biggest downside to Alan wasn't the fear of failure. It was something he never considered at first. It was the fear of success.
“Thank goodness my business is doing OK," he says. “But even now I wonder just what my brother-in-law would have said if things really took off. Would he be resentful of me? Would he want to change our deal so that he can get a bigger piece of the action (i.e. equity)? Would other family members be envious or mad at me because I didn't include them?"
Failure may change a relationship. And so too might success. Alan didn't think of that when he took the money from his brother-in-law.
No, Alan wouldn't borrow money from a family member again (and happily, Alan hasn't had the need to borrow elsewhere since). But that doesn't necessarily mean you shouldn't. The data certainly shows that this type of financing is popular among business owners. But it may help to consider all the pros and cons first. And just remember—failure may not be the only thing you should be worried about.
A version of this article was originally published on July 30, 2015.