Most entrepreneurs at one time or another consider borrowing money from friends or family.
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While most of these lending deals start out friendly enough, the relationship can quickly sour if payments are missed or money is lost. It’s impossible to guarantee your business is a risk-free investment, but there are ways to limit the chances of any ill feelings among your loved ones if the investment does goes south.
When borrowing from family “the application process is easier, you can get the money quicker and you’re dealing with a person, not a bank,” says Hunter Hoffmann, a spokesman for Hiscox USA. “When things go wrong, there can be a lot of bad things. Nobody wants to talk about back payments at Thanksgiving dinner and one bad relationship can negatively impact the whole family.”
From making the terms sweeter than a bank’s offerings to drawing up a contract, here are four steps to borrowing from family without becoming the black sheep.
Step 1: Borrow for the Right Reasons
For many small businesses, especially ones in the early stages, hitting the market with their product and service without it being fully funded can be scary. Because of that they will turn to family or friends for more funding, but that, according to Grant Cardone, can be a big mistake.
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“A lot of people think they need money first,” says Cardone. “It can be a short cut that people take to avoid going out into the marketplace.” According to Cardone, business owners have to make sure they are borrowing the money because they truly need it, and not because they don’t think they are ready to hit the streets with their product or service.
Step 2: Treat it Like a Business Transaction
When it comes to borrowing from family and friends it’s easy to make the deal a handshake one, but experts say it has to be treated as a real business transaction. That means having an official contract drawn up to document the deal, spelling out the interest rates, payback schedules, due dates and other specifics, says Hoffmann. The last thing you want to do is start squabbling with friends and family about the interest rate you supposedly agreed upon, or when you said you would start paying it back.
“Even if you’re family, this is a business transaction,” says Hoffmann. “Treat this like any other business transaction and don’t let emotions play any role.”
Step 3: Make the Terms Sweet
When you borrow from a bank you have to pay interest on the loan, and the same should go for family and friends. To make the deal more palatable to your loved ones, Cardone says to consider making the terms even better than what the bank gets.
“If you are paying the bank 6% then pay your family 10%,” says Grant Cardone, author of If You're Not First, You're Last. “It needs to be sweeter for friends and family then someone you don’t know.”
Another option is to make your investors partners in the business or give them some type of equity stake.
“It should almost be onerous,” says Cardone. “You have to pay the price to borrow from family instead of thinking it’s the cheaper way of doing it.”
Step 4: Lay out the Good, the Bad and Ugly
Every business has risks and whoever is lending your business money needs to know all of them. You may have high expectations for the business and rosy projections to go along with it, but Hoffmann says you need to balance your upbeat assessment with less rosy outcomes to give the full story.
Hoffmann says the small business owner has to make sure he or she has professional and/or general liability insurance coverage to limit any potential losses from errors or lawsuits and to consider getting the money in chunks so if things start to go bad the total loss to the lender will be limited.
“Nothing every goes exactly to plan with a small business,” says Hoffmann. “Definitely lay out the risk ahead of time.”