When Friends and Family Finance Your Business

You're ready to launch your new business. Your credit cards are tapped out, you rent your apartment (making you ineligible for a home equity line of credit), your personal credit's less than stellar and your bank is not interested in lending you money for your new venture--at least, not yet.

At first it may seem you've run out of financing options. But don't forget about the loan source nearly 10 percent of Americans benefit from: family and friends.

Financing from family and friends definitely has its advantages. They're often willing to be flexible on financing terms. And the interest you pay them for the loan could be well below the interest rate on a bank loan or credit card.

But there's an added obligation when raising money from family and friends: the need to preserve the personal relationship. You want to be more careful--not less--that you handle the investment properly. After all, if you default on a bank loan, the bank doesn't take it personally. If you're not clear on your financing terms with family and friends, you risk having them give you the evil eye every time you see them at a holiday, birthday or other celebratory event.

Here's the safe way to handle this delicate situation properly:

• Know how much you need. Don't get sloppy because you're getting funds from sources who know you. They may be taking an extra degree of risk to help you launch your dream, so treat that generosity respectfully. Present them with a thorough business plan that discusses how much money you need, how it'll be used and when it's likely to be repaid.
   
• Be clear about the form in which you want it. Funding can come in three forms: debt (through a loan), equity (owning a piece of the company) or gift. Each form has different tax ramifications for the funder. Each form has different expectations for when, how and whether the funds will be repaid. Each form entails a different level of involvement the funder will have in your business. Discuss what's best for both of you.
   
• Know whom you're asking. Think carefully about the temperament of the person whose funds you're requesting. Is he or she uncomfortable taking risks? Is he or she a busybody? If the answer to those questions is "yes," you might not want to ask that person for funding. Seek out people who will take a professional approach to your business. The last thing you need is an old college roommate assuming that you owe him--or Cousin Sue screeching, "Nice for you to take a week in Florida. Some of us can't afford it since we loaned money that hasn't been paid back!"
   
• Document the transaction. Treat this transaction as though you were dealing with a bank or independent angel investor. Have all of the proper documentation so that the terms of the deal are crystal clear. If the funder is lending you money, have a written promissory note stating the interest rate, payment schedule and penalties for late payments. If the funder is buying a piece of your company, have a written shareholder or operating agreement (depending on whether it's a corporation or an LLC, respectively) that indicates the funder's ownership percentage and entitled percentage of the profits. That's in addition to any other rights or obligations of ownership.
   
• Stay in touch. Your family and friends want you to succeed. Providing you with the money to launch your dream is one way of demonstrating those feelings. Thank them and keep them excited about the chance they've taken on you by keeping them in the loop. If you run into any problems, go to them immediately--especially if you need to skip or reschedule a payment. They'll appreciate the courtesy. You might also find that they provide a wonderful sounding board and network to help you grow your business.

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