Friends and family of new entrepreneurs are the greatest single source of outside funding but just because it’s common, doesn’t mean you shouldn’t use caution.
If you plan to bankroll a new business with a loan from loved ones, you’d be in good company.
Sam Walton borrowed $20,000 from his father-in-law to help launch what would become Wal-Mart. Berry Gordon launched Motown records with $800 borrowed from family. Richard Branson owes his business start to a loan from his Aunt Joyce.
Friends and family of new entrepreneurs are the greatest single source of outside funding. Indeed 38 percent of startups get help from loved ones, according to this entrepreneur breakdown with 2013 data from Fundable.
But just because it’s common, doesn’t mean you shouldn’t use caution. A new business is an inherently risky investment and most fail. If your business failed, how would that impact your relationship with your family member? To minimize the potential fallout, here are some key questions to ask:
What are your other options?
When I teach classes at the San Francisco office of the U.S. Small Business Administration, many new entrepreneurs mistakenly think they have to bankroll their business privately and bootstrap toward profits. Here, Main Street should take a lesson from the Silicon Valley. There are other funding options available.
Credit was tight for small businesses as the economy emerged from the recession of 2008 but there’s evidence funding has turned a corner. More than 18 percent of U.S. small businesses report lending was easier in the first quarter of the year, compared with 11.8 percent two years ago, according a Thumbtack and Bloomberg survey.
Competition from peer-to-peer financing sites like the Lending Club and Prosper, and crowdsourced ventures like Kickstarter, are pushing the trend. My small-business team recently put together this comparison tool to help evaluate traditional and nontraditional lending sources for small-business owners. Bottom-line: Compare and understand all options before going to loved ones.
Can your loved ones afford it?
Seems like a no-brainer but honestly, do you know your parents’ net worth? If not and you plan to ask them for financial help, it’s time to find out.
Often parents like to be generous with their kids. But if that generosity impacts their retirement plans, that should trigger alarm bells. Do you have an accurate picture of what this gift means to their financial health? Borrowing the amount necessary to start a business requires you ask these kinds of questions before you accept their cash.
Put it in writing.
Is it a gift, loan or a slice of the business? Once you decide family funding is for you, clarify your terms. Are they getting an equity stake? If so, what (if any) operational control will they have? If it’s a loan, determine length of loan, repayment schedule and interest rate, if any. Transparency is key.
“Most small-business owners who go to family for money approach it like they’re about to borrow $20,” Andrew Keyt, executive director of the Family Business Center at Loyola University Chicago, recently said. “The process is too informal and that increases the possibility of tension and misunderstandings with family members down the road.”
This is not a casual exercise. Formalize expectations on repayment or equity stake in a written agreement. As the SBA recommends: “Even though you may know your lender or investor well, remember that this is a business agreement. Treat it as such.”
The relationship will change.
After taking a loan from a relative, once innocuous questions like “How’s work?” will take on a new meaning.
No matter what steps you take, this move will add a new financial dimension to your relationship. You may not talk about the loan, but it sits between you and the family member at every gathering and vacation.
What if you get divorced?
Sad as it is, many marriages break over time. What if you’ve borrowed money from in-laws that’s not repaid when your marriage sours? A difficult situation becomes even further complicated.
In your written agreement, include plans for what happens if a tension arises between you and your lender. It's better to have this discussion early while on good terms, rather than when you’re in a heated situation.
Be prepared for them to say ‘No.’
There’s a lot of reasons to turn down your request for a loan. Be prepared for that. Family can provide valuable emotional support when starting your own business. Don’t let the disappointment get in the way of your relationship: You’re going to need family now more than ever.