Taking out personal loans from friends and family can be risky. Here’s what to consider.
Most small business owners have heard the old adage about mixing business with family. It’s risky. But is it always off limits? These small business owners share how they successfully used personal loans from friends or family members to grow their businesses.
Take the process seriously
No bank or investor would agree to loan your business money without a clear plan and vision. Provide this same level of detail to friends and family members. “Create a comprehensive business plan with support from small business advisors like the Small Business Administration (SBA), so you really have an idea of how the finances are going to work,” says Leigh Melander, co-founder of Spillian in Fleischmanns, New York.
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Consider the risk they’re taking
Be very cautious in considering the risk that you’re asking your friend or family member to take. How will it affect them if the business fails? Can they afford to take this risk?
“Be extremely confident in the risk of the investment and convey that risk with the utmost transparency,” says Rob Stretch, an online marketing, SEO, and social media expert from Columbia, Missouri. “Also take into account a person’s cash position. If they lost their investment in you, what position would that put them in? This is something you should think about with any investment, but it is amplified when personal relationships are involved.”
Personal loans should be a last resort
Exhaust all other financing options before you approach friends or family for a loan. “Bring your own capital, however much you have, to the table first,” Melander says. “You need to put your own resources on the line before you ask anyone else to.”
Even if you can’t find other options, seeking other financial sources can teach you a lot about being a responsible borrower. “Look at other options, talk to as many possible funders as you can. It’s really hard to get banks to lend to startups, but you can learn a lot from talking to loan officers. You want to learn how to be a really good borrower before you ask someone who matters to you for money,” Melander says.
Create a formal borrowing agreement
In order to protect yourself and your lender, and ensure that tax requirements are met, you’ll need to create a formal, detailed loan document with the assistance of an attorney and accountant if necessary. “Get it into a [written] agreement, with everything spelled out, including early repayment, nonpayment, or late payment arrangements,” Melander says. “If they’re flexible about repayment, define what that flexibility looks like together. Sign and notarize that agreement, and make sure both parties have a copy.”
Clearly define the relationship
Is this a partnership, an investment, or a loan? Be sure that both the business owner and the lender are clear about the terms and how involved you are asking the lender to be in operations.
Brien Walton, director of the Richard E. Dyke Center for Family Business at Husson University in Bangor, Maine, does not recommend borrowing from friends or family. He cautions business owners to be aware of the blurry lines that can come from personal loans. “A ‘lender’ may believe they are an ‘investor,’ which can strain the relationship,” he says.
Prioritize repayment over your own credit history
A major downside of using personal loans to fund your business is that personal relationships will be impacted. You may have to sacrifice your own credit history to avoid losing their trust. “I make payments on the loans we owe family and friends before I pay any other bill every month,” Melander says. “While having a late credit card payment may ding my credit, that’s far better than dinging the trust that family and friends have placed in us.”
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