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.
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
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.