Cash-strapped entrepreneurs may have a hard time getting their hands on outside financing. Fearing defaults, many banks and credit unions balk at extending loans to companies that lack proven track records of profitability. As a result, small business owners often turn to their family and friends to help them launch their companies.
Although asking your father-in-law to invest in your business may be a panic-inducing proposition, the right game plan can smooth the process. Here’s a look at what you should and shouldn’t do when borrowing startup funds from your loved ones.
Know what you’re asking for
First things first: know exactly what you’re after. Do you simply want a loan, or are you offering your family member a stake in your business for their investment? The less business acumen your potential lender has, the more likely it is that you’ll want a loan. Mike Moyer, adjunct lecturer of entrepreneurship at the University of Chicago and Northwestern University, suggests opting for a standard, interest-bearing loan.
“Start making regular payments right away,” he says. “These are easy to structure, and making payments will help position you as a responsible person. If the company fails, you should continue to make payments until the debt is paid off with interest.”
To keep payments low, Moyer recommends structuring longer terms of up to 10 to 15 years.
Provide a business plan
Just because you’re asking for a cash infusion from people you know doesn’t mean your professionalism should go out the window. That means you should provide your family and friends with a thorough overview of your company in the form of a well-crafted business plan.
“Although you’re not pitching your business to a bank or venture capitalist, a business plan is still essential for receiving an investment from your family member or friend,” says Taylor Johnson, a business plan expert and advisor for BusinessPlanToday.com. “Make sure that your business plan includes a clear repayment structure that is fair and, more importantly, is based on accurate forecasts.”
Don’t hide the risks
When pitching your business idea, be open and honest about your venture. Highlighting your excitement and optimism doesn’t mean you have to sell your concept as the “next big thing.” There’ll be risks involved for anyone extending you money, and it’s up to you to explain that to them without bias.
“Make sure they understand the risks,” says Dan Laufer, co-founder of RentLingo.com, an apartment review website for which Laufer raised money from loved ones. “When raising money from friends and family, I outlined the best and worst case scenarios and tried to assess some realistic probability to each outcome. I wanted to make sure they were operating with essentially the same information as I was.”
Put it on paper
Even if you’ve come to an agreement with your parents, and regardless of the sum of money involved, be sure to put everything in writing. This signed document should be as detailed as possible, including the total amount being borrowed, the interest rate, the proposed payment schedule and a plan describing how you’ll spend the money.
Because this type of lending has become increasingly popular, peer-to-peer lending websites like TrustLeaf have emerged to help make the process easier. TrustLeaf, which focuses specifically on lending between family and friends, drafts loan forms as well as repayment agreements for a fee. Though a third-party facilitator certainly isn’t necessary, it can help you stay organized and on top of your financial obligations.
Don’t let relationships suffer
It’s up to you to make sure that your business partnerships don’t hurt your relationships with family and friends. After delivering your pitch, make it clear that you won’t take a refusal personally. If you have been extended money, ease any initial anxieties your lenders might have by paying back loans in full and on time. This will establish trust going forward. Lastly, be transparent about your company’s progress — your family and friends will be eager to see how they’ve helped shape your business.
For more information about how to start and run a business, visit NerdWallet’s Small Business Guide. For free, personalized answers to questions about starting and financing your business, visit the Small Business section of NerdWallet’s Ask an Advisor page.
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