Raising Money from Family
and Friends
This article deals with the
issues that often arise when a person borrows or raises capital from a family
member or friend. More often than not, people’s feeling get hurt, or the
business is very successful and your friend that lent you the money to start the
business now wants a part of the company. By having well written contracts and
carefully documenting all transactions, you can avoid many common pitfalls.
First, of course, the legal
disclaimer
Please note that the
information in this guide is not to be used as consulting, accounting, or legal
advice. The following information is provided with the understanding that this
article is not a substitute for professional advice, and is merely for
informational purposes. BizPlanDB.com is not responsible for the use of any
information contained below or for the factual accuracy of any statements made
below.
The Article
Raising money from friends and
family for business purposes is not uncommon. Nearly 1 in 10 Americans has asked
a friend or family member for money to start or finance a new or existing
business. Typically, the interest rates, loan covenants, and terms/conditions
are far more flexible than that of a traditional bank loan. Unlike a bank, a
friend or family member often invests in the belief that you will do a good job
in starting and running the business versus a bank that solely basis its
decision on the quality of the collateral and investment.
However, borrowing money from
friends and family can present a number of problems, especially if the business
or investment fails. Feelings of resentment may overwhelm a once happy
relationship. There are many ways this can be avoided, including the use of
carefully drafted legal documents that exactly spell out the terms of the
investment, whether the investment is a loan or for business ownership, and the
payback period. You should take the step of hiring an attorney to draft all
documents so that all documentation is in line with state laws regarding the
transfer of money for investment purposes.
In regards to a loan, a formal
promissory note should be drafted that spells out the exact terms of the loan,
the payback period, the interest rate, and an amortization table the shows the
monthly or quarterly division of interest and principal that you will pay to
your lender. There should also be clauses for what happens in the event of a
business failure, if you will still be responsible the loan, and how assets can
be liquidated to return the principal to the lender. Making a transaction
between you and a friend/family member should always be done at an
“arms-length.” This will ensure that each party is well aware of the risks and
possible losses to be faced in the event of a business failure.
If you are seeking an equity
investment versus a loan, the capital risk is shouldered by the investor. When
you sell equity in your business, you are selling the future right to receive
financial benefits from the business. Unlike a loan that has a set payback
period and no profit participation on the behalf of the lender, an equity
investment provides the owner with a stream of profits and capital appreciation
for as long as they are an investor in the business. Recently, a number of
entrepreneurs have developed specialized hybrid debt and equity models that
combine benefits and disadvantages of each so that a lender receives a regular
stream of income and profit participation. This is further discussed in the
Royalty Based Financing article.