If you’re trying to raise money for your business, turning to your friends and family may be a good place to start. Instead of looking to a bank or other lending institution, sourcing funds from friends and family can be more accessible and often allow for better rates and repayment terms.
However, lending always comes with risk. Borrowing from friends and family, if not approached correctly, could lead to potential consequences that could strain your relationships or even result in unintended legal issues.
Key takeaways
- Funds provided by friends and family are a common and flexible way that startups and small businesses secure financing.
- Financing can be provided in the form of loans, gifts, and equity stakes.
- If not properly handled, lending funds could result in risk of tax liabilities for both parties.
Upon your approach, be prepared to have a conversation outlining your plans for the business and addressing questions or concerns. The key steps outlined below should help you in preparing to discuss and construct your request for financing.
Step 1: Understand Friends & Family Financing Types
In raising capital for your business, turning to your friends and family is often a cheaper and more flexible arrangement than traditional financing from a lending institution. While the process is generally more lenient, it’s relatively similar to the requirements of getting a small business loan or other startup business loans.
It’s important to know what kind of financing you can partake in. That being said, there are a few ways in which you can receive support.
Here are the financing options you can consider:
- Loans: The most common type of financing from friends and family is a standard loan. Essentially, they lend you money to put toward your business, which is structured by an agreement with terms agreed by both parties. The loan should be repaid in monthly installments, along with interest.
- Equity: In exchange for financial assistance, equity—instead of repayment—can be offered. This is a viable option if perhaps you are unable to afford a monthly payment. Notably, you’ll likely incur input and expectations from your investors as to how to run your business.
- Gifts: These are trickier to maneuver and should only be accepted as a last resort. They should be approached with the expectation that you’ll have tax liabilities and ambiguity in regard to conditions set by your personal relationship with the gifter.
You should treat any financing opportunity with the same responsibility and liability as a traditional loan. This includes applying an applicable interest rate and repayment terms. The IRS supplies an index of applicable interest rates, which provides the minimum interest rate expected for all loans. Without payment of interest, the funds could be construed as a gift by the IRS and taxed accordingly.
While loans are the preferable source of funding, if you opt to offer equity stakes, then be sure to practice due diligence in evaluating your investor’s returns and provide reasonable expectations. This is especially important if your investor may not have business or venture funding experience.
With that, there’s a chance you may be subjected to unrealistic presumptions and unsolicited business advice regarding the strategy and future success of your business and, ultimately, cause strain within your relationships.
Step 2: Select Who You Should Approach
When considering who to approach for funds, it should be someone you trust and ideally someone with experience that you can lean on. Do your research as to who may be the best fit for your business needs.
Here’s some criteria you should look for:
- Those with enough capital to provide for your business
- Someone who may be a seasoned investor
- Someone with experience in business who can offer advice
- Those comfortable with potential risk
This is a good rule of thumb when shopping around for any kind of investor, as you want resources who are knowledgeable and familiar with the process and potential liability of investing. Oftentimes, you can make connections with others who have ample advice and can steer you toward other fundraising opportunities as well, including angel investors or venture capitalists.
For more information, read our articles on angel funding and how to raise venture capital funding.
Step 3: Develop Your Business Plan
Writing a business plan is essential in preparing your funding request. This will showcase your short- and long-term goals for your business, along with actionable steps on how to achieve them. It also provides insight to your potential investors as to the structure, market, and future success of your business and allows them to address any questions or concerns.
A good way to present your business plan is to provide a pitch deck. These include generally 10–15 slides that provide key points to your presentation in a timely manner. Essentially, this is to display the elements of your business or product and how funds will be utilized.
Consider the following when drafting your business plan and pitch deck:
- Who and what does your business represent?
- Do the services or products you’re offering solve a problem?
- Is there a driven market for your product or service?
- What do competitors offer, and what sets you apart?
- What does the structure of your company look like?
- What’s the timeline of your goals?
- How much funding will you need?
- What does future company growth and financial performance look like?
Step 4: Determine How Much You Need & How You’ll Use It
Determining how much funding you’ll need is crucial when planning for your fundraising request and is an essential element of your presentation. In deciding how much funding you’ll need from your friends and family loan, factor in the entirety of your business goals.
This can account for equipment purchases, purchase of inventory, maintenance or repair costs, initial startup costs, and more. Be reasonable in the amount you’re asking for to ensure financial stability for both you and your friends and family.
Once you’ve planned out all costs for your business needs, you will also need to factor in repayment of your loan and budget accordingly. Use your calculations of total costs and compare them to your estimated revenue to determine what you can afford to repay monthly. You should also reference your estimated revenue if you’re offering equity, as your investors will likely be interested in what they can expect to gain.
Step 5: Present to Friends & Family
In presenting your business plan, it’s best to come prepared. Rehearsing your presentation can provide you with the confidence to speak clearly and informatively to your audience. You should include key takeaways such as funding amounts, operating structure, and future projections.
The goal is to present relevant information in a timely manner (aim for 10–20 minutes), inclusive of feedback and questions. From here, the opportunity to create an agreement stems from conversation and potential negotiations.
Step 6: Negotiate & Prepare Your Agreement
When drafting your agreement, there’s a good chance you’ll need to negotiate terms. A discussion regarding the interest rate, loan term, and repayment method is warranted. It’s important to hear out all options and make an informed decision that won’t impact your relationships or cause legal trouble. You should create a legal document that outlines all terms, such as a promissory note or equity contract, to avoid any future discrepancies.
Here are a few things to consider when drafting your agreement:
- Detail what type of financing and implications will be provided:Â Whether it be a loan, a stake in equity, or a gift, be sure to list the expectations of each.
- Define the rate and terms of the loan:Â Similar to a loan agreement with a lending institution, you should get everything in writing and map out an applicable interest rate, the length of the loan term, and your repayment method. Make sure to comply with IRS regulations to avoid unintended consequences.
- Set achievable goal points that will promote the growth of your business:Â This instills confidence in your investors and paves the way for loan payoff or return in equity stakes.
- Be transparent about any risks: If you’re a small or startup business with limited resources, the risk for return on investment can impact your investors. Be straightforward in your discussions regarding how funds will be used.
- Consider hiring an attorney:Â While not always necessary, an attorney can act as a safety net in drafting the conditions of the agreement. It protects both you and your investor and tidies up any legal obligations.
Pros & Cons of Raising Money From Friends and Family
| Pros | Cons |
|---|---|
| Is less formal than traditional bank loans | May have potential tax liabilities if the funds aren't documented properly |
| Benefits small businesses or startups with limited capital to grow their business | May risk personal relationships if you offer stakes in your business |
| Offers flexibility to either borrow funds or offer equity in the business | Comes with the risk of being unable to return the investment |
Alternatives To Friends & Family Loans
If you decide to go another route or are unable to obtain financing from friends and family, there are a few alternatives to funding startups or small businesses.
Here are a few options to consider:
- Small Business Administration (SBA) loans: These are government-backed loans for small businesses with solid credit.
- Rollover for Business Startups (ROBS): You can use funds from your personal retirement account with an investment of $50,000 or more.
- Equipment loans: These allow businesses to finance a piece of equipment needed for business operations.
- Personal business loans: These are personal loans based on your personal credit with flexible funds that can be used towards your business.
Frequently Asked Questions (FAQs)
If the loan amount is greater than $10,000, interest paid can be considered taxable income for the person who provided the loan. For the one who received the loan, since it will be repaid, it’s not considered income and won’t have tax implications.
Put your agreement in writing with clear terms. Consulting a legal professional is highly recommended to ensure compliance.
It can be, if funds are given without terms of repayment or if a loan is forgiven.
Bottom Line
Borrowing or raising money from friends and family can be useful when securing financing for your small or startup business. Whether it be a loan, gift, or stake in equity, it’s a common and flexible way to raise money for your business, usually with better rates and more lenient terms.
There are many factors to consider when pursuing a friends and family loan, including your personal relationships and tax or legal obligations. It’s important to structure your agreement accordingly to prevent risk and to protect both your business and personal relationships with investors.
