When you need to raise working capital for your small business, borrowing money from family or friends can often be your best option. You don’t have to go through a credit check or fill out a bunch of forms, and the emotional connections you have make it more likely that they’ll say yes.
The downside to borrowing money from friends and family comes when things don’t go according to plan and you have trouble paying them back. Even though your father may forgive a small loan and your good friend may give you more time to pay, tensions will inevitably arise when money you promised to pay back is not. To avoid friction in the family or losing a close friend when you borrow money, follow some basic ground rules.
Clearly Communicate the Reason You Need a Loan
It’s important to be completely honest and forthcoming when asking to borrow money from a friend or family member. Let them know exactly what you plan to use the money for and how it will help your business. Your friend or family member will feel more comfortable lending you money, and more confident that they’ll be repaid, if the money is spent wisely.
Risk and Reward
Every loan, no matter how big or small, carries some default risk. Borrowers should expect to pay a higher interest rate when they present a higher risk of default to lenders. In the case of borrowing money from friends and family, you should offer a fair interest rate commensurate with the risk associated with the loan.
Assure your lender that you’ll do everything possible to make sure they’re repaid. As long as you are completely transparent about your business, they should have no trouble assessing the risk of default. Family and friends should be fully aware of the risks and rewards before agreeing to loan any money.
Set the Loan Terms in Writing
A small business loan requires a more formal agreement than might be the case when you borrow some money from a friend for personal reasons. A handshake and your word may be all that is necessary to get your friend to lend you $200 to repair your car. But asking a friend to lend you $20,000 so you can scale your small business is an entirely different matter.
To avoid any disputes after a small business loan has been given, it is always best to set the terms of the loan in writing. Both parties should sign a formal loan agreement to ensure there is a clear understanding of the obligations of both lender and the borrower. The loan agreement or contract should address the same points as if you were borrowing money from a bank or business financing company.
- Date that the loan was made
- Amount of the loan
- Interest rate on the loan
- Length of time allowed to repay the loan
- Terms of repayment – monthly payments, lump sum etc.
- Late fees or penalties for not repaying on time
- Available remedies to lender if borrower defaults on loan
Remove All Personal Feelings from the Transaction
Sure you may be able to talk your friend or family member into letting you repay a loan over a longer period of time, but don’t take advantage of a close personal relationship or put undue pressure on them. Never mistake a friend or family member’s generous offer to extend a loan to your small business as an invitation to change the original terms of the loan agreement.
If you don’t want to damage the relationship between family and friends, don’t make them chase you for repayment. If you’re having difficulty repaying according to the agreed terms, let them know your situation as soon as possible. Perhaps the original agreement can be modified, or your friend or family member will be amenable to a new arrangement.
Involvement in Your Business
Tension can arise if they suddenly want to become more involved in your business. Unless you want a partner or are asking for more than just money, make it clear from the beginning that you don’t want their constructive “help.”
At the same time, don’t discourage your family member or friend from coming down to your business once in a while! Remember to be friendly and cordial because in addition to the business arrangement you made, you also want to maintain strong personal relationships.
Ground Rules to Remember
- Communicate and be truthful with family and friends
- Create a written loan agreement
- Discuss what is and is not expected
What do you think? Have you ever borrowed small business capital from a friend or family member, and how did that work out? Remember, you can always get a small business loan in Credibly.