The first financial supporters of new businesses are often family and friends of the founders. According to research, 36% of funding for startups comes from family and friends. Furthermore, family and friends invest on average $23,000 in a startup. This article will explore the complexities of accepting this money in the form of equity or a loan, how to minimize friction once the investment is made, and one potential tax issue related to paying interest.

If you are planning on raising money from friends and family, you want to be doubly sure your business and personal banking accounts are clearly separated. If not, you’ll run into some serious ethical and tax issues down the road. If you are ready to get started with a business bank account, check out Chase. Their business checking account has low fees, one of the best ATM/branch networks in the nation, and allows unlimited monthly cash deposits.

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Did you know? If you have more than $50,000 in your retirement account you can use this money to start or buy a business without paying early withdrawal penalties.  Click here to learn more.

Should you give equity (stock) or a promissory note to family and friends that want to invest?

The idea of giving stock to family and friends is enticing. If the business does great, you will have the opportunity not only to make yourself rich, but also enable your supporters to share in your success.

Even a little bit of stock received very early on in a company’s life can make an investor rich. I remember a story about a painter that was decorating Facebook’s first office and received payment in stock. In the version of the story that I heard, the painter became a millionaire as a result of a few days of work. Wouldn’t it be great if you could make your friends and family rich?

On the flip side, there are benefits to giving stock if the company does poorly.  Money invested in stock doesn’t have to paid back if the company goes bankrupt. A business owner does not necessarily have to spend years paying back investors, as they might with debt.

The Three Big Problems With The Equity Approach To Funding A Business

Problem 1:

Most Companies Aren’t Inherently Designed To Be The Next Facebook or Groupon

If you’re opening up a restaurant, hair salon or hundreds of other businesses, a successful outcome doesn’t necessarily lead to a situation where friends and family can turn their stock into big financial gains. Even if a company is doing well, for example producing a half a million in profits per year, your family and friends may not be able to turn their stock into cash.

Potential buyers for stock of companies where minority shareholders have little or no control are hard to find.  When a business owner sells their friends and family stock, in many cases they are sticking them with an illiquid investment.

Problem 2:

Friends and family that own stock are minority owners.

Even if friends and family own only a small sliver of a company, they may feel that they have the right to weigh in on company decisions. Family get togethers can potentially feel like a business meeting in which the owner must listen to hours of unwanted advice.

Problem 3:

There is the question of valuation.

How much is your company worth? Early stage companies are very difficult to value.  The founders of companies often have unrealistic expectations, which tend to get re-adjusted during the process of raising money from professional investors and financial institutions.

The Alternative To Equity: A Loan

While a loan is not as sexy as equity, it does not have the problems mentioned above. If the company is successful, friends and family will get back what they invest and earn interest. Even if the business doesn’t work out in the long run, a business owner may be able to pay back some or all the money, particularly if the business owner is making monthly payments.

When friends and family loan money, they are not minority owners. While they may want to give you “free and helpful” advice, they may not feel as entitled to help make company decisions. Furthermore, a business owner may not need to share as much detailed information about what is happening at the company with debtholders.

The Right Way to Borrow Money

When borrowing money, there are a few key question that you need to decide.

1. Personal Or Business Loan
2. What interest rate and for how long?
3. How should the loan be documented and the loan payments be handled?

Personal or Business Loan?

While business owners many not see much difference between them and their company borrowing money at an early stage, there is big difference from a legal perspective.  It can be much simpler and less expensive to take money as a personal loan, rather than borrowing money as a company. However, taking the loan as company provides some separation between personal finances and the business, possibly enabling the owner not to be required to pay back the debt if the business goes bankrupt. These differences and others are discussed in detail in our article on promissory notes.

What Interest Rate?

AFR Minimum Rates – An interest free loan can be a very bad idea, even if the lenders don’t care about receiving a positive return on their money. The problem is the IRS might take the opinion that the loan is in fact a gift (and subject to gift tax) from the borrower, rather than an investment.

One test that is applied is the interest rate charged on the money. The IRS publishes an index of Applicable Federal Rates, which are the minimum rates they expect on loans based on the term of the loan. Applicable Federal Rates are updated monthly on the IRS website. In October 2014, the minimum interest rate was 0.38% for loans of less than 3 years, and 1.85% for loans of 3 to 9 years. These rates are much lower than “market rates”.

A Market Based Approach

There are firms, such as Lending Club,  that provide personal loans for business purposes. The average interest rate changed by these firms is around 15% per year. As the purpose of a friends and family loan is to help a person start a business, the loan rate should well be below these market rates. An interest rate in the neighborhood of 6-10%, represents the mid-range between the AFR minimum rates, and current market rates.

What should be the length of the loan?

It takes some time for a business to establish themselves. It often takes businesses three to five years to start turning a profit. The longer the loan, the smaller the loan payments, and the easier it will be for the business to succeed during those first few critical years. If putting the business in a good financial position to survive is the primary concern, a loan of 10 years or longer makes sense.

However, most startups don’t last 10 years. Many businesses last only 3, 4 or 5 years. Most business owners want to pay back their borrowers while the business is an ongoing concern. A loan of 3 to 5 years represents a compromise between how long new startups tends to last and putting the business in the best position succeed.

While the borrowing can be paid back in one lump sum or installments, we highly recommend the funds are paid back in equal monthly installments during the term of the loan.

How should the loan be documented and payments handled?

There absolutely should be a legal document, a promissory note, signed when money is borrowed. A promissory note will provide clarity to both sides on the following issues:

1. How much is being borrowed?
2. At what interest rates?
3. When will payments be made?
4. What are the consequences for non-payment?

Without the promissory note to put things in black and white, there is a much greater opportunity for misunderstandings and disagreements later on. While there are a plethora of free promissory notes available online, we highly recommend that using a paid service, such as ZimpleMoney or TrustLeaf for personal loans and InvestNextdoor for business loans.

These companies can also provide assistance in the logistics of providing monthly payments to borrowers. For example, ZimpleMoney offers a service in which you make one lump sum payment and they handle the distribution to borrowers. TrustLeaf takes a more basic approach. It sends both the borrower and lender email reminders that a payment is coming up, and for the amount that should be paid. However, TrustLeaf has more functionality around sharing the opportunity for friends and family to invest in debt.

Did you know? If you have more than $50,000 in your retirement account you can use this money to start or buy a business without paying early withdrawal penalties.  Click here to learn more.