Many small business owners use business loans to finance their enterprise. But with the recent tightening of lending standards, business owners may need to explore other means of raising capital. One good source of business financing that is often overlooked is money from relatives and friends. (To learn the basics of business financing from family and friends, including how to ask for money and document the deal, read Nolo's article Private Loans & Investments: Raising Money From Family and Friends.)
There are three main financing options when it comes to raising money from friends and relatives -- gifts, loans, and equity investments. Learn about each one so that you can make the best choice for you and your potential lender.
Gifts from Family and Friends
A gift is the simplest way of obtaining business capital. You have no ongoing obligation to the giver (although you should thank the person and make an effort to maintain good relations). A friend or family member might offer a gift of money to help you get started, or you might jumpstart the process by asking. Though it might seem impolite to ask someone for a gift of money, when you're starting a business, it can make sense.
To document a gift, all that's necessary is a letter explaining that the money is a gift. The giver should keep a copy for tax purposes, to assure the IRS that the transfer wasn't an interest-free loan. You should keep a copy as well. You may receive up to $12,000 each year from any one person as a tax-free gift. If you receive more than $12,000, the giver must file a gift tax return (IRS Form 709, U.S. Gift Tax Return) for the amount given over $12,000. (To learn more about taxes on gifts, see Nolo's article Reduce Estate Tax by Making Gifts.)
Business Loans From Family and Friends
Most financing from friends or family comes in the form of a loan. Someone gives you money and you promise to pay it back, usually with interest, over a set time period, and in accordance with certain terms.
Documenting the Loan
For your sake and the sake of your lender, it's best to set up every loan the way a bank would: with a signed agreement, called a promissory note, and a repayment schedule. Following these business standards will increase confidence in prospective lenders, and these documents will protect your lender from having the IRS treat the loan as a gift.
The written documents should spell out in detail when and how you're expected to repay the money -- including what to do if the payment is late. Once you've signed the promissory note, it's legally binding.
Choosing an Interest Rate
Friends and family who lend you money are often willing to do so at below-market interest rates. Chances are they're more interested in supporting your efforts than in turning a profit, and some might even insist on earning no interest at all. As you prepare to approach prospective lenders, however, you should plan on paying interest, for several reasons:
- Paying interest helps ensure that you meet IRS guidelines for private lending, which treat overly low interest rates as a gift to the loan recipient, which counts toward the lender's $12,000 gift maximum.
- A respectable interest rate, similar to what your lender would earn on a savings account or CD, may make your lender happier about the whole arrangement.
- For prospective lenders who aren't that close to you, offering an interest rate that exceeds what they'd earn elsewhere is a great way to attract their attention.
Considerations When Getting a Private Loan
If you are considering a private loan arrangement, understand that you'll have to regularly manage the loan, usually by making monthly payments. This might be difficult if your business isn't making money. Of course, your private lender is likely to be more flexible than a bank if you can't meet your repayment obligations. But you should seriously consider whether you and your business can handle these monthly payments before signing onto a loan.
Family and Friends as Equity Investors
A third way to raise business capital is to sell shares in your business to an "equity investor." Although many businesses seek out professional equity investors, your friends and family members can also become equity investors in your business.
How Equity Investments Work
Unlike a lender -- who temporarily provides you with money to operate your business -- equity investors actually buy a piece of your business. They become your co-owners, or shareholders, and share in the fortunes and misfortunes of your business. (To learn more about equity investments, read Nolo's article Raising Money Through Equity Investments.)
Raising money for your business through equity investments is very different from raising it through borrowing money. (For more on the difference between loans and equity investments, read Nolo's article Loans and Equity Investments Compared.) You'll need to:
- compensate your investors for the risk they've agreed to take on
- share ownership in the business
- comply with securities laws, and
- put all these agreements into a legal document unique to your financing situation, probably with the help of an attorney.
Compensating and Protecting Equity Investors
Equity investors take on a high level of risk -- often investing $50,000 or more with no guarantee that your business will make money. Your investors should understand and accept that they are not guaranteed to get their money back.
To make the risk worthwhile, equity investors stand to win big if your business succeeds. If your business grows fast, investors will earn a lot more than they would have by merely making you a loan and collecting interest. For example:
- If a friend loans you $10,000 and you repay it at 6% over 2 years, your friend will make $637 on the loan.
- If a friend buys a 10% stake in your $100,000 company, and it then becomes a $500,000 company, your friend's investment will have earned far more than $637.
Equity investors can also take steps to protect themselves as much as possible from business failure.
Equity investors can make sure that they stand a better chance than any other investor of getting their money back if the business goes belly up. They draw up long, complicated legal documents that ensure they will be able to collect a return, sometimes at two or three times the initial investment, leaving other less-privileged company co-owners (like you) with nothing.
- Equity investors can stay informed and involved in your business by, for example, taking a seat on your board of directors or requiring reports on both financial and operations matters.
Sharing Ownership in Your Business
Equity investments mean dealing with shared ownership. Your investors will have some say in the way you run your company. This isn't to say that you should avoid equity investors, just that you should know what you're getting into.
Documenting an Equity Investment
You'll need to create an equity purchase agreement and other documents to formalize an equity investment in your business. This paperwork can be complicated and will determine who owns and controls your company, so you will probably want to consult with an attorney.
Depending on how many investors you take in and how much money you raise, you may also need to comply with federal and state securities laws. You will likely need to hire an attorney to ensure that you comply with these laws and deal with the required paperwork.
Finally, you'll want to learn about how having investors will affect how you file your taxes, and you should inform your investors of the tax consequences of their investments.
For more information on every aspect of private financing -- from making your pitch to preparing the appropriate paperwork, get Business Loans from Family & Friends: How to Ask, Make It Legal & Make It Work, by Asheesh Advani (Nolo).