Intro

One of the biggest myths about private lending is that entrepreneurs like yourself are essentially preying on the charitable instincts of your friends and family—using your desperation as a way to extract money, all the time knowing that your friends and family may never see that money again. The truth is much different.

Yes, there are risks involved for people who lend to a start-up business, even if those people are related to the founder. But you can take various steps to protect both the money and the relationship. And reason aside, sometimes relatives and friends are willing to lend a helping hand right when you need it most.

“The funds from friends and family was our first round of financing and let us get the first phase of our business in place; if we hadn’t had that money we couldn’t have gotten started,” remarks one entrepreneur launching a smoothie shop in Verrado, Arizona. “We used it for the deposit on the location and a consulting service to get things going; the money played a large role getting the ball rolling and definitely was a huge part of getting us where we are now.”

This chapter will take an honest detailed look at what each side has to gain from this financial relationship—starting with you, the entrepreneur, moving on to your family and friend lenders, and concluding with some thoughts on how to successfully mix money and relationships.

What’s in It for You, the Entrepreneur?

Let’s start with the easier question: What advantages do private loans offer you and your business, especially as compared to other financing alternatives? The four most important advantages are that private money:

• may be available when other capital is not
• is often cheaper
• offers great flexibility, and
• represents validation from your key supporters.

Private Loans May Be Available When Other Money Is Not

If you’ve already maxed out your personal sources of cash, but don’t yet have the collateral or revenue to attract bank or professional equity financing, the advantage of private money is obvious: It’s your best, and sometimes only, source of capital to start up (or expand) your business. You’re not alone in this situation—many entrepreneurs face a capital gap at this most critical stage in their new ventures.

Most banks will deem a start-up too risky for a loan, once they’ve compared you against the five Cs checklist (Capacity, Capital, and so on) described in Chapter 2 “How Banks Choose Whom to Lend Money To”). That takes you right back to your friends and family, to whom you are a known quantity. They know your strengths and weaknesses. They probably won’t do a five Cs evaluation of your loan request or even a credit check (though you might impress some by offering to provide one). Your friends’ and family members’ belief in you is an intangible personal asset that you can use to your advantage—and turn into a tangible business asset.

Other options, such as professional venture capital, are likely to be a waste of your time for reasons discussed in Chapter 2. Fewer than one in 10,000 entrepreneurs open their doors for business with venture capital on hand (2006 GEM Financing Report). But that doesn’t mean there’s no one willing to take a gamble on you and your business idea. Start close to home and look to the people who already know and trust you, who might also be willing to put some money behind you. Chances are you’ll be able to find friends and family and even a few business colleagues to take a chance and loan you money when you need it most. Later on, you can worry about attracting the attention of the heavy hitters.

Private Loans Are Often Cheaper

Even if you could get a bank loan, the high fees and interest rates might make it an overly risky choice for your fledgling business. Banks, credit card companies, or other financial institutions will charge you marketrate fees and interest and possibly high penalties if you are slow to repay. Your interest rate will be inversely linked to your credit score; in other words, the lower your credit score, the higher your interest rate. Even a small business banker or a microlender is likely to charge 10% interest or more. From their standpoint, they’re gambling on an unknown quantity and want to be assured of some reward to cover their risk. These days, financial institutions are not big fans of taking risks on loans!

By contrast, family, friends, and other private lenders tend to be focused on helping you. You’ll find that most of them simply hope that you will succeed and that they will get their money back. They may protest at the very idea of your paying interest, assuring you that a rate of 0% is just fine. Or you may be lucky enough to get an outright gift. In other words, friends and family are typically not out to make money off the deal. This doesn’t mean you should take full advantage of their generosity—as you’ll see in Chapter 6 which discusses how to pick an interest rate, there are many reasons to pay a rate closer to market rates. Nonetheless, even if you go as high as 6 to 9%, which is currently typical for private business loans, you can still come out ahead in a market where credit is hard to come by.

For example, the popular SBA 7(a) small business loan cost as much as 8% in the summer of 2009 (see “Interest Rates Under the SBA 7(a) Loan Program,” in Chapter 2). If you’re borrowing from a lender without the benefit of an SBA loan program (which provides a government guaranty for the loan as long as the interest rate charged is below certain limits), your rate may be even higher.

Private Loans Offer Flexibility

Loans from banks and other institutional lenders are nearly always standardized so that the lenders can manage them in a cost-effective manner. By contrast, one of the joys of private lending is its flexibility. This comes in handy at two important junctures: First, when you set up your repayment plan, and second, if and when you need to make changes to that repayment plan. You’re not up against an institution that preprints thousands of standard-form loan contracts and would be horrified at your suggestion that it alter a single clause. Instead, you’re borrowing from someone who is just as interested in a feasible repayment plan as you are.

When you sit down to create a schedule for your repayments, you should think first about what you can afford, and then create a schedule that makes keeping up with your payments possible. Don’t assume that you have to follow the typical bank model, in which small business loans are “amortized”—meaning that repayment is scheduled to begin immediately, at a set amount for every installment. With your private loan, you have the option of designing a repayment plan that more closely matches your business’s expected schedule for turning a profit. For example, your schedule could start with a six-month grace period (where you don’t make any payments), then switch to interest-only payments for the next 12 months, then move to a graduated (gently increasing) payment schedule for 36 months. You’ll see in Chapter 9 how to design a repayment plan to fit your situation.

Profit predictions being uncertain, however, your well-laid repayment plans may turn out to be impossible, or nearly so. This is the second time when your friends’ and family members’ understanding and flexibility can literally save your business, by allowing you to make adjustments to your repayment plan.

Example: Runako starts a catering company with a loan from his mother, set up as a month-to-month repayment plan. While Runako’s food suppliers demand immediate payment, his customers are less attentive to the calendar. One month, after catering two large weddings, Runako realizes that his payment to his mother is due the next day, while the brides and grooms who owe him money have seemingly left on long honeymoons. Fortunately, with a simple call to his mother, Runako is able to delay that month’s payment— without the penalties that a bank might have charged.

As long as you communicate with your lenders early and clearly, temporary adjustments to your repayment plan may allow you to recover from the many bumps that you will probably encounter on the road to success. You can call this “patient capital”—financing that is flexible and allows you to repay as you are able.

TIP: Private loans can also help you build your credit rating. Historically, one of the downfalls of private lending has been that when borrowers did a good job making payments, only they and their lenders knew about it. Now, loan servicing companies provide borrowers with optional credit reporting services, so that repayment performance is reported directly to the national credit reporting companies. In this way, the on-time payments on your private loan from relatives or friends can help establish or improve your business’s credit rating, which makes your business look like a better credit risk if and when you go to the bank for subsequent financing. For a list of loan servicing companies, see www.P2P-banking.com.

Private Loans Represent Validation From Key Supporters

The advantages of having your earliest investors include people you know may be personal as well as financial. Entrepreneurs report that the validation they feel from receiving the financial support of family and friends can be a big boost. The start-up phase is usually a very difficult time in the life of both the entrepreneur and the business. Money is tight, both personally and in the business, and even the most minor decisions count.

You may be exhausted after launching your computer consulting business, staying up late at night after coming home from your “real” job and skipping weekend social events to meet a code deadline for your first customer. Or you may be learning painful lessons about how a rainy holiday weekend can wreak havoc on your beachside bike rental shop. Your family (particularly your spouse or partner) may be feeling the stress of your single-minded focus on the new business, at the expense of personal priorities. At times like these, having people you know express their belief in you and your idea by writing a check can mean a lot.

What’s in It for Your Family and Friend Lenders?

The more you hear about the benefits that loans from friends and family offer you—low interest rates, the possibility of putting off repayments in a pinch, and emotional support during rough times—the worse a deal they might sound like for your lender. Yet, seen from your friends’ and relatives’ point of view, the reasons to do it are actually quite rational and solid. These include:

• altruism, or an unselfish concern for your welfare
• self-interest, in cases where the lender might benefit financially from the loan, and
• a recognition that by combining your resources, both you and your lender can come out ahead.

Making a Loan May Satisfy Altruistic Motives

Some people, particularly those closest to you, may be motivated to lend you money (or even give you an outright gift) out of an unselfish desire to support you. Their sense of personal commitment is so strong that it outweighs any considerations of financial gain or loss. For example, your parents are practically hardwired to want to see you succeed. It’s not a far step from the pride they gain from seeing an A+ on your report card or watching you hit a home run—particularly if they can tell their friends about it.

Or perhaps you have a best friend who’s always thought of you as the sibling he or she never had and who has supported you every time you’ve asked. That friend is likely to want to help your business for altruistic reasons. Altruistic lenders help out because they can, and in some cases, also to try to provide you a developmental opportunity and to nudge you towards independence.

Example: When Kyle realized his own savings wouldn’t be enough to launch his health consulting business, he did what most entrepreneurs do, he asked for support from family and friends. He sent an email describing his plans, and offered to send a business plan to anyone who was interested. Old friend James received one of Kyle’s emails. “I took advantage of the opportunity when he offered … more so to say that I believe in him than the actual financial part of it. I came up with an amount I could do, from there Kyle suggested an interest rate and payment schedule, and I just chose one.”

Ironically, entrepreneurs are often most hesitant about taking money from people to whom they feel the closest, out of concern that the lender will be disappointed if the business fails. However, it’s usually only when entrepreneurs actually deceive others about their business’ prospects that true disappointment sets in. No one wants to find out that their nearest and dearest has conned them. If you are doing your best at running your business, and are openly communicating about your business’ financial situation, your family and friend investors are likely to be unusually patient and forgiving about the business’ fits, starts, and even failure. (Indeed, their very patience can be the key to your business’s eventual success.)

Making a Loan May Satisfy Self-Interested Motives

Although altruism runs deep in the human psyche, people must consider their own interests, too. In fact, experts researching intrafamily lending have found that self-interest is the main reason that most family members agree to finance a business start-up. That’s good news for you: You don’t have to feel like a beggar, and you don’t have to limit your requests to your most saintly friends and relatives. There’s a certain comfort in knowing that a lender acting out of self-interest is also a lender who has evaluated the options and believes that the opportunity you are offering is a good one.

TIP: Watch out for lenders with hidden agendas. There’s a difference between self-interest and utter selfishness, and you’ll need to distinguish between the two. For example, someone may be lending you money so that later he or she can call in the favor and ask you to do more than you’d ever bargained for. You’ll learn more in Chapter 4 about how to sort through your circle of contacts and identify your “best bet” prospects.

Loans Can Make Money for the Lender

A private loan is, at its most basic, a financial transaction. Any lender who is not operating out of pure altruism will approach the deal with an eye toward the market. People will probably compare the terms of the loan you’re offering with what they could get (or are getting) by putting the same amount of money in a savings account, CD, or other investment. If you can offer a better return with acceptable risk, lenders may well take you up on it. (Chapter 6 explains how to come up with an interest rate.)

I once made the mistake of asking a possible angel investor why he was considering my company. He contorted his face, implying it was a silly question. Obviously, his motivation was to make money. Because I had been raising money primarily from close friends, work colleagues, and relatives up to that point, I had forgotten that some of my contacts would be simply motivated by financial returns—and I realized that no one is going to protest if the loan makes them a decent return, not even your grandmother.

Example: Sumalee wants to start a shop in Los Angeles selling Thai desserts. She approaches her tax accountant about a loan of $4,000, offering to repay the principal (original loan amount) plus 8% over the course of three years. The accountant is financially savvy enough to know that he could never earn that kind of return on a three-year CD. Of course, Sumalee’s offer presents many risks—retail shops are expensive to set up and operate, and Thai desserts are not yet well known in the United States. What’s more, the FDIC won’t come along and bail Sumalee’s lenders out if her venture fails, as they would if an FDIC-insured bank failed. Nevertheless, the accountant knows that Sumalee has a good head for business and he likes the idea of an 8% return on a shortterm loan, so he lends her the $4,000. The 8% rate she offered was enough to overcome her accountant’s concern about the risk normally associated with a small start-up retail shop.

Private loans are financial opportunities that your friends, your family, and even other people to whom you’re not as close might evaluate and rationally choose to take advantage of. As long as you provide accurate information about your business’s prospects, it’s ultimately up to them to decide whether your offer has a chance of providing a greater return than other uses of their money.

Lenders Like Getting Involved With a Successful Business

Some entrepreneurs enjoy helping others get a start, by providing financial support and cheerleading in the early stages. They are likely to value your entrepreneurial spirit and feel good when they can use their knowledge and experience to foster that spirit. They did it themselves and are eager to be a part of it all over again.

Example: Jennie is both an entrepreneur and an experienced business lender. The owner of a successful women’s fitness business, Jennie currently has nine outstanding loans to friends and colleagues ranging from $8,000 to $35,000. In each case, someone she knew came to her with a business idea that was related to her area of expertise and caught her imagination. She made one loan to a feminist ethnographer, one to a water-birth center, and one to a maker of women’s workout gear. Jennie made sure that all the loans were formalized with the proper documentation and serviced through a loan servicing company, so that she doesn’t have to spend her valuable time watching the calendar for late payments. Although some of the borrowers are doing well and others are struggling, Jennie gets satisfaction from her involvement and support in each of the nine businesses.

Lending Often Serves a Mixture of Motives

Behavioral experts say that few lenders are motivated solely by altruism or self-interest. Most often, their decision making is driven by a combination of the two. This makes particular sense when you realize that the boundaries between altruism and self-interest aren’t always clear—for example, when your grandfather glows with joy at your success, is that altruistic sentiment or self-interested pride at the accomplishments of his gene pool?

We’ll leave the distinctions to the academics—your lender will probably catch onto the “win-win” aspects of your proposal pretty quickly. And nowhere is this simultaneous mix of interests clearer than in the family setting, where private loans can help maximize overall wealth and serve the elder family members’ estate planning goals.

For example, in some families, loans between parents and children or other younger generations serve as a form of intergenerational wealth transfer. Parents or other relatives who were already planning to leave you money can transfer it to you now, when you really need it to launch your business, and potentially avoid taxes by doing so. (See Chapter 3 for tax implications of loaning money.)

Even if your lenders prefer not to make the transfer an outright gift, but to style it as a loan, the net result is beneficial. That’s because, if you view the family as one unit, the unit as a whole comes out ahead financially: Why should you pay interest to a bank, rather than to your family (who may eventually gift or leave the money to you, anyway)? Or why should some anonymous investor reap big rewards because you had the skills and determination to make your business a roaring success, when you have friends and family able to play the same role?

TIP: Early asset transfers, such as private loans, are particularly beneficial for wealthy families. Under current federal tax laws, estates worth over $3.5 million are heavily taxed when the person dies. Reducing the estate value to less than that amount through early transfers of money is beneficial for everyone.

There's no doubt about it, raising money from people you know can feel like asking for a favor. But, if you get into this mindset, you’ll compromise your very effectiveness. Think about it this way: You are offering someone the opportunity to get involved in an exciting business venture, to play a role in your success, and even to earn a little profit.

Mixing Money and Relationships Can Work

At this point, you may be thinking, “Okay, I see the benefits, but doesn’t someone often get hurt when you mix money and relationships?” After all, even William Shakespeare advises us: “Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry” (Lord Polonius in Hamlet). A badly handled loan or investment could probably do a lot more damage than dulling the socalled edge of husbandry. Indeed, numerous current-day commentators will tell you to steer clear of relationship loans altogether. Maybe you’ve seen cautionary news headlines such as these:

• “Funding and family: Mix with care.”
• “It’s all relative: A family loan can be a recipe for disaster ... it doesn’t have to be.”
• “Are intrafamily loans hazardous to your financial health?”
• “Preparation vital before seeking friends and family loan.”
• “Banking close to home: Starting a business with help from friends and family doesn’t have to mean making enemies.”

Despite all these prophecies of doom, the simple truth is that most of the relationship bruising that happens around loans occurs because the transactions were handled badly in the first place. That’s where this book comes in—it will help you make the loan relationship clear and legal at the outset, to avoid miscommunications, misunderstandings, and basic mistakes. With a little planning, you can structure the deal in a way that protects relationships and allows both parties to achieve their goals.

Still, you may have more specific concerns about mixing business with friendships and other relationships. Below are some of the leading concerns I’ve heard from borrowers as they consider asking for private loans, combined with a preview of the best practical means to forestall these concerns. (I’ll get into the practical details in later chapters.)

If you’re worried that: “I don’t want to disappoint my lender if I’m unable to keep up with the payments I promised.”

Be sure to: Carefully watch your cash flow situation, and communicate problems to your lenders as soon as you’re aware of them. Generally, when you borrow from friends and family, they aren’t fixated on receiving your payments by each deadline and will be flexible if they think it will help you succeed in the long term. If you’re having difficulty making payments, be up-front with your lender about your situation, and suggest an alternative repayment plan that works for both of you. In most cases, your lender will appreciate your proactive response and accommodate your request—which should ultimately allow you to get your business back on its feet.

If you’re worried that: “My lender will constantly be anxious about the possibility of my business failing—and hate me forever if it does.”

Be sure to: Realize that yes, lenders may worry, and business failure at this early stage is a risk you are responsible for making clear to them. If a particular lender ranks high on the worried scale, but might be more willing to make the loan with some protection against the risk, you can offer to secure the loan with collateral. Collateral significantly reduces your lender’s risk because, if you default on the loan, your lender will be entitled to receive and sell the item of collateral (such as a vehicle or office equipment) in lieu of being repaid. If you do have troubles, but you are honest and open about the situation, your lenders are highly unlikely to hate you.

If you’re worried that: “Even after I pay my lender back, the lender may still feel as though he or she did me a favor and that I owe something.”

Be sure to: Pay your lender a fair interest rate from the get-go. Even better, pay the lender more than the money would earn in a similar investment. If yours is a three-year loan, make sure to pay more than a three-year CD would earn. When you set up the loan, point out the market factors based upon which you picked the rate. That should help satisfy lenders that you owe them nothing after the loan has been repaid. Also, by using a formal loan request to ask for the money, and then a legally binding promissory note (your promise to repay the loan) to formalize the deal, you help make clear that this is a business transaction, not a favor.

If you’re worried that: “My lenders will meddle in how I run my business.”

Be sure to: Formalize the loan with proper documentation, to make clear that this is indeed a loan, not a case of your leaning on the person for aid. Seeing that you are serious about treating the loan in a businesslike manner should help your lender understand that his or her role doesn’t extend beyond that of a lender.

If you’re worried that: “My lender will scrutinize everything I spend money on that isn’t related to my business. What if I buy a new coat or take a vacation; will the person wonder whether I’m doing it with his or her money?”

Be sure to: Set up a mutually agreed-upon repayment plan, so that your lender will always know that you were current on your obligations to pay back the loan before you spent anything on yourself. Of course, if your business is hobbling along on other people’s money, it’s not wise financially or personally to make extravagant purchases. The best way to keep your lenders out of your business is to sign a repayment plan and stick to it.