Raising Money from Family and Friends

This article deals with the issues that often arise when a person borrows or raises capital from a family member or friend. More often than not, people’s feeling get hurt, or the business is very successful and your friend that lent you the money to start the business now wants a part of the company. By having well written contracts and carefully documenting all transactions, you can avoid many common pitfalls.

 

First, of course, the legal disclaimer

 

Please note that the information in this guide is not to be used as consulting, accounting, or legal advice. The following information is provided with the understanding that this article is not a substitute for professional advice, and is merely for informational purposes. TheFinanceResource.com is not responsible for the use of any information contained below or for the factual accuracy of any statements made below.

 

The Article

 

Raising money from friends and family for business purposes is not uncommon. Nearly 1 in 10 Americans has asked a friend or family member for money to start or finance a new or existing business. Typically, the interest rates, loan covenants, and terms/conditions are far more flexible than that of a traditional bank loan. Unlike a bank, a friend or family member often invests in the belief that you will do a good job in starting and running the business versus a bank that solely basis its decision on the quality of the collateral and investment.

 

However, borrowing money from friends and family can present a number of problems, especially if the business or investment fails. Feelings of resentment may overwhelm a once happy relationship. There are many ways this can be avoided, including the use of carefully drafted legal documents that exactly spell out the terms of the investment, whether the investment is a loan or for business ownership, and the payback period. You should take the step of hiring an attorney to draft all documents so that all documentation is in line with state laws regarding the transfer of money for investment purposes.

In regards to a loan, a formal promissory note should be drafted that spells out the exact terms of the loan, the payback period, the interest rate, and an amortization table the shows the monthly or quarterly division of interest and principal that you will pay to your lender. There should also be clauses for what happens in the event of a business failure, if you will still be responsible the loan, and how assets can be liquidated to return the principal to the lender. Making a transaction between you and a friend/family member should always be done at an “arms-length.” This will ensure that each party is well aware of the risks and possible losses to be faced in the event of a business failure.

 

If you are seeking an equity investment versus a loan, the capital risk is shouldered by the investor. When you sell equity in your business, you are selling the future right to receive financial benefits from the business. Unlike a loan that has a set payback period and no profit participation on the behalf of the lender, an equity investment provides the owner with a stream of profits and capital appreciation for as long as they are an investor in the business. Recently, a number of entrepreneurs have developed specialized hybrid debt and equity models that combine benefits and disadvantages of each so that a lender receives a regular stream of income and profit participation.