Thinking about asking Grandma for a loan to expand your storage facility? If you are, you wouldn’t be the first entrepreneur to reach out to a relative for money.
Seventeen percent of small business owners used private loans from family and friends for financing, according to the National Small Business Association’s 2013 Mid-Year Economic Report. From that same report, 15 percent said they’d seen reduced credit lines recently, and 69 percent said they’d been hurt by the “credit crunch.”
If you’re ready to ask your best buddy for a loan, first consider this old American proverb: “Before borrowing money from a friend, decide which you need most.” Then, if you must borrow from family or friends, follow this advice to avoid foreclosure on those relationships you value most.
1. Explore Other Options First.
Borrowing from friends and family is “not the place I would start,” said Stephen Bush, CEO of AEX Commercial Financing Group. Ask a relative for a gift of money rather than a loan. Apply for a loan from your bank or credit union, and if you’re not approved, ask the lender to consider your request under the U.S. Small Business Administration’s Loan Guaranty Program, which can back as much as 85 percent of a small business loan.
Still, “you always need a Plan B,” according to Bush, and that might be a private loan. “If resources aren’t available from the bank and you really want to do this,” he said, “you may not have any other alternative.”
2. Borrow Carefully.
Getting a bank loan is fairly impersonal—here are the rules, take it or leave it. If you don’t repay, you’ll face seized collateral and foreclosure.
Borrow from your brother, though, and that transaction gets complicated, said Manny Skevofilax, president of Portal CFO Consulting. Your brother might lend $20,000 to you, even if it drains his savings, simply to preserve the relationship. If you miss payments or can’t pay him back, though, the relationship with your brother will suffer.
“Smaller amounts of money can cause relationships to end,” said Skevofilax, who recommends against borrowing from family and friends. “It’s just not worth it.”
3. Expect Changes.
It’s “almost a certainty” that relationships will be strained by unexpected events, Bush said. In the world of financing and investing, things go wrong. Let’s say you borrow money to buy a storage facility in a military town and plan to pay it back based on a steady stream of rentals by service members. But what happens if the local military base shuts down?
“There are going to be times when things are not so rosy,” Bush said, “and friends and family may not understand.”
4. Develop a Written Plan.
“I’ll pay you back when I can” almost certainly will lead to trouble. Put together a one- to three-page summary that lays out plans for the money, potential problems and a repayment timetable, Bush said. Explain why you’re turning to that person rather than a bank for money.
5. Be Clear About Strings Attached.
If you don’t want help running your business, you need to tell that to the lender. In some cases, you may have to offer partial ownership for the lender to secure the loan, Bush said. Be prepared for questions about how much power the lender will wield when it comes to business decisions.
6. Be Honest About Risk.
Even if Uncle Joe can afford to take a hit, be upfront about the possibility of a loan default. “You need to tell people who loan you money that it can be 100 percent lost,” Skevofilax said.
Keep in mind that you’re also risking your reputation if you can’t repay. “A bank can foreclose, but they don’t necessarily talk bad about you at the Rotary Club,” Bush said.
Prepare a promissory note that outlines the loan amount, repayment terms and interest. If the lender also wants to take interest in collateral, a security agreement (UCC-1 for personal property) or security deed (for real property) also should be drawn up, Zucker said.
It’s best to hire a business or real estate attorney to prepare paperwork, but you also can complete forms yourself from online sources. All documents verifying the loan need to be signed by the borrower and be notarized.