If you've ever caught one of those daytime courtroom shows on TV, you've probably seen that borrowing money from loved ones can go horribly awry. This popular image of friends-and-family loan disasters—with lenders and borrowers locked in knockdown, drag-out financial disputes—is enough to sour anybody on the idea.
But in reality, friends-and-family loans are a popular source of startup cash for many small businesses and actually can end happily—provided you approach it in a smart, informed way.
Here are five steps to taking a friends-and-family loan in a way that works for everyone involved.
1. Choose your lender wisely.
Just because someone is a friend or family member doesn't make them a great choice to be your friends-and-family loan provider. Make sure you choose someone who is financially sound, savvy and knowledgeable about the potential risks of investing in your business.
The SBA recommends you "select someone with solid business skills who knows the risks and benefits of what they are getting into. Remember, if your business doesn't work out and you can't repay your obligations, relationships will suffer. At the very least, narrow your list down to friends or family who have faith that you will succeed, who understand your plans and are clear about the risks."
If you're unsure whether a family or friend lender is the right fit, consider starting with a smaller-than-needed loan to test drive the potential relationship.
2. Do your homework.
Showing passion for your business is crucial, but so is due diligence. Even if you don't have an elaborate business plan mapped out, it may be a good idea to bring your friend or family lender something in writing that shows you've taken some time to research. Include your intended use for the funds—be as realistic and specific as you can—as well as a suggested repayment schedule. With any loan, it is good practice to have an ironclad plan for repayment even before committing to the funds. But when it comes to friends-and-family loans, it can be absolutely necessary.
3. Clarify their role.
You and your lender should discuss whether the funding will be a traditional loan, where they give you a certain amount of money and you pay back them (with interest) over a set period time. Or, would they rather give you money and, in return, gain an actual share in the business? This is an important distinction, as it will determine how much involvement they have in the company's operations.
One option can be to make your friend or family member a company shareholder. By making the transaction an investment instead of a pure loan, your friend or family member may be able to write off the loss on their taxes if the business fails. (This can only happen if the amount your business received for stock isn't over $1 million). It also means that they stand to see a significant return on investment if your business is very successful.
That said, a loan is the better option if you wish to remain autonomous in business decisions. Think carefully—and discuss at length with your friend or family member—as to which model is the best for your situation.
4. Document your agreement.
When borrowing from family or friends, it's tempting for both parties to agree to “terms" that are little more than “Pay it back when you can." But this vague approach is a bad idea, which can lead to resentment and relationship strife, withdrawal of support, tax consequences and even legal action.
Even if the terms of your agreement are somewhat loose—such as postponing payments until your company turns a profit—it may be wise to make sure that you have everything in writing and signed. This will help keep all parties in a “strictly business" mentality and document the loan terms in case of later dispute. It will also help protect you, your business and your lender from tax and legal ramifications.
5. Communicate effectively after the loan.
Your lender most likely will want to keep tabs on the loan and on the progress of your business. Make sure to check in regularly to keep them apprised—and, of course, to make payments. If your lender is a shareholder, the necessity of consistent communication is even greater for the sake of making informed business decisions.
Don't let visions of loan-related blowouts deter you from seeking a startup capital from a relative or friend. A friends-and-family loan can be a great funding option—as long as you are cautious and communicate clearly.