Many small business owners use business loans to finance their enterprise. But with the recent tightening of lending standards, business owners might need to explore other means of raising capital. One good source of business financing that's often overlooked is money from relatives and friends.
You have three main financing options when it comes to raising money from friends and relatives:
Learn about each one so that you can make the best choice for you and your potential lender.
A gift is the simplest way to obtain 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 jump-start 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. You and the giver should keep a copy of the letter for tax purposes to assure the IRS that the transfer wasn't an interest-free loan.
You can receive up to $16,000 each year from a person as a tax-free gift. If you receive more than $16,000, the giver must file a gift tax return (IRS Form 709, U.S. Gift Tax Return). The IRS gift tax exclusion amount changes annually; check the IRS website for current rates. (To learn more about taxes on gifts, see our article on reducing your estate tax by making gifts.)
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.
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.
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:
If you're 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.
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.
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.
Raising money for your business through equity investments is very different from raising it through borrowing money. With equity investments, you'll need to:
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're 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.
Equity investors can also take steps to protect themselves as much as possible from business failure. For instance, to stay informed and involved, they can take a seat on your board of directors and require reports on financial and operations matters.
Equity investors can also make sure that they stand a better chance than any other investor of getting their money back if the business goes belly up. They can draw up long, complicated legal documents that ensure they'll be able to collect a return—sometimes at two or three times the initial investment. A high return could potentially leave other less-privileged company co-owners (like you) with nothing.
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.
If you're considering having equity investors in your business, you must determine which ownership structure will work best for you and your investors.
If you recruit people to invest in your sole proprietorship, your business will, by default, become a general partnership. This conversion means your equity investors will be general partners, each of whom is personally liable for business debts and liabilities, regardless of whether they take part in running the business.
Many investors will want to insulate themselves from personal liability for business debts, particularly if they're not going to actively participate in running the business. If your investors prefer less liability, consider other ways to organize your business.
Corporations offer shareholders protection against personal liability for business debts (called "limited liability"). A shareholder of a corporation who doesn't participate in corporate activities and decision making is virtually free from liability for corporate debt or activity.
A shareholder who helps run the company can be liable to outsiders for their own actions. For example, they would be liable for making slanderous statements or negligently operating a piece of equipment if injury resulted from their actions. But a shareholder isn't personally liable for corporate debts or the actions of corporate employees.
Not everyone chooses a corporation as their business entity. Organizing and running a corporation involves some initial and ongoing paperwork, as well as some fairly substantial start-up costs.
If you form a limited partnership and your investors become limited partners, they'll have limited personal liability for business debts. A limited partner's freedom from personal liability is similar to that of a corporate shareholder, as long as the limited partner doesn't become actively involved in running the business.
Every limited partnership must have a general partner who's personally liable for the debts of the business. That'll probably be you, so you should evaluate your exposure to risk before you decide to form a limited partnership.
Another option is to form a limited liability company (LLC) and sell membership interests in the LLC to your investors. LLCs combine the limited personal liability of a corporation with the tax advantages of a partnership, and they've become increasingly popular in recent years. (For more information, read about the basics of LLCs.)
The law treats corporate shares, limited partnership interests, and (usually) passive LLC membership interests as securities. Federal and state securities laws regulate the issuance of these securities to investors.
Before you sell an investor an interest in your business, learn about securities laws requirements.
Exemptions. Fortunately, there are generous exemptions that generally allow a small business to provide a limited number of investors with an interest in the company without complicated paperwork. Most exemptions depend on who invests, how much is invested, and whether the interest can be transferred.
If you aren't exempt, reconsider. In the rare cases in which your business won't qualify for these exemptions, you have to comply with the complex disclosure requirements of the securities laws—such as distributing an approved prospectus to potential investors—and register the securities. In this case, it might be too much trouble to distribute the interest unless a lot of money is involved.
Err on the side of disclosure. Even if you qualify for exemptions to the securities disclosure rules, investors could accuse you of providing misleading assurances. Always suggest that potential investors check with their own financial and legal advisors to evaluate the investment. The bottom line is that, although each investor will assess their own degree of risk, you should disclose all the relevant information to them so they can make an intelligent, informed choice.
For more information on complying with securities laws, see our FAQ on corporations.
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'll probably want to consult with an attorney.
Depending on how many investors you take in and how much money you raise, you might also need to comply with federal and state securities laws. You'll 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.
While you might not want to involve a lawyer when working with friends and family, consulting one can be a good idea for both sides.
A small business attorney can make sure an equity investment is fair both for you and the investor, and they can take care of any tax or reporting obligations. They can also help with a personal loan by drafting a promissory note, preparing a repayment plan, and advising on interest rates.
If a family member or friend gives a gift, it could be a good idea to consult with a tax attorney to make sure you and the giver are receiving the best tax benefits from the gift. A lawyer can also draft a letter documenting the gift that's acceptable to the IRS.