New Equity Expert Series: Borrowing from friends and family

Every small business has growing pains, and difficulty in securing financing sits at the top of the list of challenges. Many entrepreneurs that are unable to get favorable terms or enough money from their local banks turn to family members to help finance their businesses. But beware – borrowing money from people you love has its drawbacks. You must be extremely careful and make it a priority to establish realistic repayment terms and strong lines of communication.

The Value of Family and Friends

Today’s lenders are more frugal than ever. Banks have tightened their underwriting parameters and investors are only lending to businesses with long track records of success. This could be bad news for business owners who just don’t have the history to launch their ideas. This is why so many emerging and aspiring entrepreneurs turn to family and friends – a source of funding that is often far more receptive to new business propositions. These are people who love and trust you. Typically, as long as you show the necessary confidence, financial foresight and endurance to implement your concept and plans, family and friends will respond favorably to your loan requests.

The amount of money that you can secure will vary depending on the means of your family. I have seen some family members Fifty percent of businesses fail within their first five yearspool together and provide as much as $150,000 for a start-up while others are able to produce only $10,000-$20,000 from savings. What you need will obviously vary depending on the concept and scope of your business, but if you have planned effectively, even a small amount will be sufficient to help get you off the ground.

Take a company like 1-800-FLOWERS as an example. In 1976, James McCann borrowed $10,000 from friends and family to purchase a flower shop in Queens, New York. He quickly grew his shop into a chain and used the money to buy 1-800-FLOWERS and turn it from a company bleeding cash into a multi-million dollar empire that today ranks as one of the largest florists in the world.

Avoiding the Pitfalls of Borrowing from Friends and Family

I would be remiss if I didn’t mention the potential pitfalls you’ll face borrowing from your inner circle. To start with, there is a huge potential for failure. According to the Small Business Administration, fifty percent of businesses fail within their first five years. This can present a number of challenges if you don’t think ahead and do some aggressive contingency planning. Here are three ways to effectively mitigate these risks:

1. Have a Business Plan in Place

   Every business seeking a loan from a bank must have a carefully crafted business plan with financial records, plans for the future, and a clear vision of how the money will Having a business plan can help convince your family and friends that you know what you are doing…and that you have a solid understanding about how their money will be usedbe used to turn that business into a profitable venture. Just because you’re borrowing from family doesn’t mean you should skip this step.

   In fact, having a business plan can help convince your family and friends that you know what you are doing, that you are serious about your plans, and that you have a solid understanding about how their money will be used to build your business. It can also help you better manage the money you receive by outlining future expenses for your start-up or emerging business.

2. Communication and Loan Management

   Make sure you have clearly outlined how family and friends will be repaid. Repayment structures can include monthly principal and interest payments, interest only payments for a defined period of time or a monthly percentage of net operating cash flow. This should be spelled out in the business plan and through a social loan management service like Virgin Money. Handshake agreements are the quickest way to create a rift between friends and family. Make sure you have Handshake agreements are the quickest way to create a rift between friends and familya funding agreement that has been reviewed by a lawyer and agreed to by all sides.

   Additionally, don’t forget to lay out what happens if you miss a payment. It might happen and the last thing you want is for your father or cousins to come around every couple of days looking for a check. Create a fee structure for late payments and always communicate in advance of when the payment is due if you are running behind.

3. Borrow from the Right Family Member

   Entrepreneurs make this mistake all too often: a business owner borrows money from his Great Aunt Judy and she calls every three days to check in on his progress and give him ideas. Avoid situations like this one. First, steer clear of debt-to-equity agreements where your friends or family buy into your business. The loan should, in fact, be a loan – If you plan on borrowing money from your loved ones, it is vital that you carefully outline the terms of the relationship in advance of accepting the fundsthis type of financing product allows you to make wholly independent business decisions. Anything else will cause confusion and create tension.

   When creating a start-up business, money is hard to come by. That’s why friends and family are such attractive funding sources. However, if you plan on borrowing money from your loved ones, it is vital that you carefully outline the terms of the relationship in advance of accepting the funds. Don’t just assume things will work out on their own. Have a business plan, have a loan agreement, and communicate early and often. Only then will you avoid potential misunderstandings that can create deep and lasting issues between you and your friends & family that too many entrepreneurs have faced in the past.