Borrowing From the First National Bank of Uncle Steve

Any discussion about using money from friends and family needs to start with two facts, says Rebecca Gubbels, UMKC Small Business & Technology Development Center:

Rebecca Gubbels, UMKC SBTDC

Rebecca Gubbels, UMKC SBTDC

  1. This type of funding happens to be one of the most popular for young businesses. According to the Kauffman Foundation, friends and family are the No. 3 source of money after the owner’s savings and credit cards.
  2. Traditional lenders have an acronym for these kinds of loans, FF and F. It stands for friends, family and other fools.

For small business owners just getting started, it’s likely easier to obtain $10,000 from Uncle Steve than from the local bank.

But introducing a business transaction into a personal relationship can sour feelings between loved ones and undermine a small business.

The secret to avoiding problems, Gubbels says, is to treat these kinds of agreements with the same level of respect granted to any other major business transaction. Remember that ultimately, it’s a loan, not a favor.

Everything is negotiable

The beauty of friends-and-family loans is that practically everything is negotiable, Gubbels says. Friends and family can choose to lend more money for longer periods at lower or no rates than an institutional lender ever could.

“The only constraints are what the business needs and what the family member is willing to offer,” Gubbels adds.

Friends and family also might be open to flexible repayment schedules based on milestones rather than fixed dates. Uncle Steve, for example, could decide that monthly loan payments don’t have to start until the business has recorded two consecutive months of sales above $1,000.

And unlike a bank, Uncle Steve already knows who you are. Instead of looking into the business owner’s credit history and financial resources, friends and family want to know more about the business itself and how the money will be used.

“Every outside source has to learn who you are,” Gubbels says. “With friends and family, you skip that step.”

While everything is negotiable, that doesn’t mean everything should be negotiable. For example, friends-and-family agreements should make clear that entrepreneurs are borrowing money, not selling equity in (and thus, control of) their company.

Even if both sides agree, don’t be surprised when loved ones push the boundaries to complain about decisions or offer unsolicited advice.

If you hated when Mom nagged you about cleaning your room, just wait until she digs into your P&L statement.

Get everything in writing!

Gubbels strongly urges entrepreneurs to put all the terms of their friends-and-family agreements in writing.

Maybe the written agreement can take the form of an informal letter. Maybe the business owner and the lender hire an attorney to draft a formal note. (If you go that route, Gubbels says, try to have most of the details worked out before hiring the lawyer — it could save you some money on legal bills.)

The complexity of the agreement will depend on how sizable the loan feels to either party. Uncle Steve, flush from his Powerball win, might not care if he ever gets his $10,000 back. But if Grandma Carol took that $10,000 out of her 401K, the loan will be a much bigger deal. She’ll want to understand all the details.

“If in doubt,” Gubbels says, “get a lawyer involved.”

Both sides should also agree on the following questions:

  • How big will the loan be?
  • How will the loan be repaid? When are payments due, and how long does the borrower have to pay off the entire debt?
  • What kind of return can the lender expect? While some friends and family might be OK with not charging interest, others will expect a return that reflects the level of risk they’re assuming.
  • How will the funds be used? What say, if any, will the lender have in business operations? Gubbels notes that, generally speaking, bankers don’t get any direct input on operational matters.
  • How will disputes be handled? If the business fails, will the owner still be personally obligated to pay off the remaining debt? For Gubbels, the answer is yes — otherwise, that loan is really a gift.

Some friends-and-family lenders might decide they’re not really going to enforce the terms of the deal, but Gubbels encourages them to keep that fact to themselves. Otherwise, a business owner could lose the incentive to put in the hard work that enables them to pay back the loan — and, coincidentally, make their company successful.

– Contributed by James Hart, managing editor, Thinking Bigger Business Media. Used with permission.