A Guide to Business Loans From Family and Friends

Loans from banks and credit unions can be difficult to qualify for when an entrepreneur wants to start a new business or has less than stellar credit. Instead of traditional funding options, these business owners may turn to the informal funding option of business loans from family and friends.

The family and friends funding startup option has a number of advantages over other types of small-business loans, including no formal loan application process and flexible loan terms. However, there are some disadvantages. Getting a loan from a family member or friend won’t help build your credit history, and there’s the potential it could damage your relationship if things don’t go as planned.

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What is a family and friends business loan?

A family and friends business loan is typically a personal loan where the lender is a family member or close friend of the borrower. It can be an option for entrepreneurs who have been unable to secure other forms of funding to start or expand their business.

While family and friends business loans are typically informal, with no application process, credit check, document submission or collateral request, it’s still important that the agreed-upon loan terms be put in writing.

Pros and cons of family and friends business loans

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What to consider before asking family and friends for a business loan

A loan from family or friends can be extremely helpful when you need financing for a business, but not being able to pay back the loan can cause rifts in relationships.

Here are some questions you may want to answer before you move forward:

• Have you exhausted all other funding options?

• Are any family members or friends in a position to lend you money?

• Will you take it personally if someone says no to your request?

• Are you open to getting business advice from your “lenders” after receiving the loan?

Loans vs. investments

Both loans and investments can provide funding for a business. However, there are some key differences when talking to family and friends about contributing money to your business.

A loan involves an obligation to repay the borrowed funds to your family member or friend. Loan terms typically include interest rates, monthly payments and loan repayment periods. And a loan doesn’t involve giving the lender any ownership in your business.

In contrast, when family and friends invest in your business, there is no obligation to repay the funds they give you. Instead, the money received is in exchange for partial ownership of your business and, potentially, a share in future profits.

How to set up a business loan from family and friends

How you choose to approach family and friends for financing will be unique to your situation. However, taking a professional approach similar to what you'd use when seeking traditional financing will likely help. Here are some steps to consider taking:

Prepare a business plan

You typically prepare a business plan to get a loan with traditional lenders like banks. Similarly, a business plan can be useful in persuading your family and friends that your business is a worthwhile investment. In the funding request section of your business plan, you may want to include the loan terms you’d like to receive from your family and friends.

Decide who to approach

Based on the loan amount you need, you’ll want to decide who to approach for financing. Give some thought to which family members and friends are in a position to offer you a loan. For example, a retired family member on a fixed income is typically not in a position to loan money. On the other hand, a friend who has a well-paying job and extra income may be a better candidate to offer assistance.

You may also want to take into account your existing relationship with the person. For example, a family member who you’ve previously borrowed money from and repaid is likely to be more receptive than a family member with whom you have a tense relationship or ongoing dispute.

Give your presentation

When it comes to encouraging your family and friends to loan you money, a professional presentation that includes a market analysis and sales plan will likely be better received than a quick request for money with few details.

Also, be honest about the risks involved in lending you money for your business. Typically, your family members and friends won’t be experienced lenders capable of assessing the risks of investing in your operation. Providing cost estimates and revenue projections can help potential lenders better understand how you will be able to repay their loan.

Create a loan contract

When it comes to business loans from family and friends, you’ll want to put the loan amount, interest rate, payment amounts, repayment period and other loan terms in a document. Having these details in writing can help avoid misunderstandings in the future.

Setting a date upon which you'll begin making payments can be helpful in demonstrating your intent to honor the agreement and pay off the debt.

Give progress updates

It wouldn't be uncommon for a family member or friend to want to receive regular reports on your progress in opening or expanding your business. It may be reassuring for them to know that you've moved forward with your plans and that you're seeing positive results. Again, it’s important to be honest when reporting your progress or lack of progress.

Consider transitioning to traditional financing when possible

Sometimes a family and friends loan is a short-term solution for your business financing. If you’ve been able to resolve an issue that prevented you from getting traditional financing, such as a poor credit score or low sales revenue, then you may want to consider re-applying for a bank loan.

Being approved for a traditional business loan could allow you to pay off the debt owed to family and friends. A traditional business loan is also useful in building business credit history, which a family and friends loan is not able to do.

Alternatives to family and friends business loans

If a business loan from family and friends is not the right option for you and you haven’t been able to get a traditional business loan, here are some alternatives to consider.

Self-financing

Your own savings, investments or retirement accounts can be used to fund your business. If you take money out of your retirement accounts to cover the cost of a new business, the transactions are called Rollovers as Business Startups, or ROBS. A home equity loan can be another form of self-financing that could get your business up and running.

However, if you use self-funding and your business isn’t successful, the result could be a loss of your savings or retirement funds, or a larger mortgage debt.

Co-signer

You may want to consider asking a family member or friend to be a cosigner on a business loan. A cosigner is an additional guarantor who supports repayment of a loan. Having a cosigner with a solid credit score may allow you to qualify for a traditional loan. Plus, the loan will appear on both the cosigner's credit report and yours, so it's an opportunity to build your credit history. However, keep in mind that failure to pay the loan will have negative consequences for both you and your cosigner.

» MORE: Best banks for small-business loans

Small-business grants

Funding can also be obtained from startup business grants offered through private foundations and government agencies. Award money can be used for a variety of business purposes, but you will face competition for this “free” capital. And the application process typically can require a significant investment of time.

Business credit cards

A business credit card may be a short-term financing option when you need to cover day-to-day operational expenses. Startup business credit cards can be easier to qualify for than traditional business loans, although your personal credit history will be used to evaluate your application.

While business credit cards often come with rewards programs based on your spending, interest charges accumulate when you carry a balance and add to the overall cost of the card.

Crowdfunding

Crowdfunding sites like Kickstarter and Indiegogo are another way for small businesses to raise funding. When you use online campaigns to raise money, you typically offer gifts, rewards or other perks to the donors. Crowdfunding can also be a way to gauge interest in your product or service before fully launching your business.