Raising Money From Friends and Family: Loans Or Equity?

Turning to friends and family to fund a business venture is one of the most common forms of small business funding. Raising money from friends and family is less formal than other financing alternatives. Business owners can give away equity to fund their business or take on debt with a friends-and-family loan.

What a Friends-and-Family Loan Is

A friends-and-family loan is one option that startups and small businesses have for starting or expanding operations. New businesses that can’t qualify for other startup business loans often borrow money from friends and family to get funding. There are many advantages to raising money from friends and family, with the biggest being its relative accessibility.

How Raising Money from Friends and Family Works

Business owners can raise money from friends and family in two different ways: by selling them equity or by taking a loan from them. Entrepreneurs that take a loan typically must make regular payments with interest until they repay the loan. Business owners that sell equity won’t make monthly payments, similar to putting personal money into a business, however, the equity entitles investors to a share of profits and ownership.

Developing a business plan and determining how much money a business needs is the first important step that would-be borrowers can take to reassure their friends and family that their business is a good investment. Friends and family like to understand the business, its progress, and how their investment will push the business to its goals. Regardless of the investment, it’s important to keep personal and business finances separate.

Whether a business owner is getting a friends-and-family loan or using equity financing, after a successful pitch it’s time to draft up the paperwork. Sometimes a simple agreement for future equity (SAFE) is best, but for larger sums, it’s a good idea to consult an attorney. With debt financing, it’s best to have a legal contract in place, because it leaves no room for misunderstanding or ambiguity.

Who a Friends-and-Family Loan Is Right For

Friends and family finance first-time entrepreneurs, new small business owners, operating startups, and business owners that struggle to qualify for other financing options. Friends and family loans are a common form of debt financing that gives both business owners and investors the opportunity to avoid the difficult process of establishing a valuation to provide funding.

Common uses for a friends-and-family loan include:

• First-time entrepreneurs: After an entrepreneur investigates their market and finds a potential need they can fill, it’s time to raise money from friends and family.
• New small business owners: A loan from friends and family can be a great way to smooth over the initial cash flow issues that most small businesses experience.
• Entrepreneurs preparing to raise angel investment: Raising money from friends and family is a great way to increase cash while raising funds from angel investors.
• Business owners struggling to get financing: A friends-and-family loan is a great substitute for traditional or alternative lenders that business owners can’t qualify with.
• Friends and family comfortable investing in a risky venture: Startups and small businesses are risky, and anyone who plans to lend should be comfortable with the risks.

Raising money from friends and family is risky for both business owners and borrowers. Not only do many businesses fail, but it can ruin personal relationships. Friends and family should understand the risks of investing and know that there is a substantial risk that the investment may amount to nothing. Professional investors in startups employed by venture capital firms only have a 20% success rate for their investments, showing that the risks of failure are substantial.

How to Raise Money From Friends and Family

Raising money from friends and family or getting a friends-and-family loan need not be complex. Borrowers should develop a business plan and a pitch deck, define how much money they need, and know what they will offer lenders. Once ready, they can identify their potential investors, pitch the project, and negotiate any remaining details.

The six steps individuals should follow to raise money from friends and family include:

1. Develop a Business Plan and Pitch Deck

When raising money from friends and family, business owners should prepare a business plan and pitch deck. This business plan helps answer questions, reassure investors of the opportunities, and deliver the best answers to investor questions.

The pitch deck is a less comprehensive presentation but acts as a quick overview of the business plan, offering less information with more graphics and soundbites about the business. The pitch decks of many successful companies like Airbnb and Uber are available online, but there is no need to duplicate them. When preparing a pitch deck business owners should focus on ensuring investors understand why the business is a good investment.

2. Determine How Much Is Needed

Raising money from friends and family requires that business owners understand the exact investment they need, which some investors refer to as “the ask.” More money is usually better, especially for a new business, but asking for a set amount helps communicate that there is a plan and that the investment has a purpose.

“One thing to be careful of is not asking for too much. Often, we think because they are friends and family, we can get more out of them than we would with another type of creditor, but that’s not always a good thing. If you take too much and don’t have a solid plan to pay back, you risk tainting your personal relationships.”

—Dr. Roshawnna Novellus, Founder, and CEO at EnrichHER

The business plan, pitch deck, and ask are the three essential components of a pitch, and like a stool that requires three legs to stand, all three components of the pitch should work together and support each other. Investors should understand when and how much profitable growth their investment will produce. In the best cases, investors and founders will also find opportunities for personal and professional growth as advisers.

3. Select the Right Type of Funding

Knowing how much to ask for is the first step to understanding what type of funding is best to raise from friends and family. The smallest funding amounts are often provided as gifts, while the largest amounts are equity. Loans are the clearest cut, while gifts are most ambiguous. Equity is the only option that gives investors direct input into the day-to-day operations of the company, and growth-stage startups use it most often.

Types of friends and family funding include:

• Loans: Debt is the most common form of financing that friends and family offer to small business owners. It requires regular payments, carries interest, but doesn’t grant them any equity. It’s best for small business owners with enough revenue to make payments and friends and family that prefer the predictability of debt.
• Equity: Diluting ownership is a preferred method of financing for entrepreneurs that don’t have the cash to make regular payments. Dilution isn’t immediate, because friends and family may need to be considered “accredited investors” by the SEC to determine a company valuation and purchase equity.
• Gifts: When fundraising, entrepreneurs should avoid asking for gifts, or money for nothing. Many times this creates an ambiguous situation in which it is unclear what each party expects. It also doesn’t define the barriers of control and privilege if the business must be liquidated.

Business owners should enter any meeting with a good understanding of the funding that they hope to secure. However, they should not be too rigid when meeting with investors. Unless there is a compelling case for certain funding, it’s important to leave room for discussion. If the most important thing to achieve is successful funding, the details take on a supporting role.

4. Select Potential Backers

Owners should seek investors that have sufficient capital, can offer advice, are comfortable taking a risk, and have a good understanding of the investment process. Otherwise, business owners must provide too many explanations only to find that there are no funds to get for the investment. Referrals from close friends and family can be a powerful tool to rely on.

Leveraging a referral is a great way to meet new potential investors and to raise money from friends and family because it includes a warm introduction. Entrepreneurs will find that the number of candidates for investment grows and with each candidate the chances of raising sufficient capital increase.

Money isn’t the only requirement that entrepreneurs should consider when getting a friends-and-family loan. Potential investors can also offer advice and guidance to entrepreneurs that can increase their chances of success and help them avoid common mistakes. Finding investors with industry experience is a great way for new entrepreneurs to access the experience and knowledge of their friends and family.

5. Pitch Friends and Family

Pitching is an activity that most people regard as a less difficult version of public speaking. Business owners and entrepreneurs should invest some time into rehearsing their speech to ensure that nervous jitters don’t get the best of them. The pitch itself should take about 10 minutes and should cover operating history, opportunity, and the amount of funding the business needs.

After the pitch, it’s a good idea to solicit feedback, because it starts a natural conversation and makes investors more confident. The discussion will soon turn to matters of details, rates, and terms. When having these conversations business owners should seek to identify pain points preventing investors from committing capital and find solutions to get the funding deal closed.

6. Set Rates and Terms

Most friends-and-family loans require simple debt agreements that business owners can find online or through an attorney. Many business owners and investors may not know what rates and terms to set. In this case, there are two options, consult an attorney or personally negotiate the rates and terms.

Founders should consider that there is an applicable federal interest rate, that the IRS requires lenders to adhere to. Known as imputed interest, the IRS will consider any loan made to have this interest as a minimum for tax purposes. This means that a friend or family loan that founders receive interest-free, will carry a tax cost for the lender equal to this rate.

Terms

As a business owner, negotiating terms for investment is difficult. The best way to start is by matching the investment opportunity to the timeline of the friends-and-family loan. For example, if a company manufactures the latest remote control toy and needs financing to hire staff for holiday orders, then it’s best to negotiate delayed repayment after the holiday season.

Rates

Rates are trickier to negotiate than terms because most business owners and investors have insufficient information in the transaction. Friends-and-family loans can be negotiated based on the prevailing interest rate, the opportunity cost of the funds, and the potential profitability of the investment for the business.

Business owners and investors that don’t feel comfortable negotiating the rates and terms of a friends-and-family loan should hire an attorney. Having counsel advise on such a deal and help structure the agreements, filings, and paperwork is critical to ensuring a good long-term relationship between both parties. Saving money upfront is good practice, but can lead to difficulties and disagreements, so it’s best to invest in legal help.

Raising Money From Friends and Family Tips

Business owners, lenders, entrepreneurs, and investors offer some advice for borrowers seeking a friends-and-family loan. They warn against the risk to personal relationships and suggest hiring an attorney, outlining risks, creating a repayment plan, and keeping the fundraising process focused on outcomes.

Six tips for raising money from friends and family include:

1. Set Specific Goals and Focus on Execution

Entrepreneurs preparing to raise money from friends and family should set some initial goals to avoid wasting time and losing track of priorities. While raising funds is important, the primary goal is almost always to continue growing the business. It’s also important to define the fundraising outcomes and to identify potential investors.

The priorities for business owners raising money from friends and family include:

• Continue to grow the business: Without growth and sound operations friends and family won’t be interested in investing because there is no evidence borrowers will put money to good use.
• Define the outcomes: Knowing the desired outcomes of fundraising and investing the money in the business is key to ensuring that entrepreneurs can assess funding offers.
• Know potential investors: Entrepreneurs seeking a friends-and-family loan should know the financial position and risk tolerance of the people they pitch. It’s important that potential investors understand both the opportunities and the risks of the investment.

2. Keep The Presentation Simple

Many entrepreneurs invest a lot of time and resources into putting together a great presentation. The bells and whistles, extra lights, extensive paperwork, and glossy paper might seem impressive but can reduce the chances of receiving funds. Investors might interpret the display as an inability to manage funds or think entrepreneurs are compensating for otherwise weak fundamentals.

3. Explain the Risks

Borrowers that are raising funds for their venture should be clear about the risks of the investment. Investors should understand the general risk of small businesses and startups and any specific risks about the particular venture they are being asked to invest in. This can be a great way to mitigate the risk of damaging relationships if the worst happens and there is no way to repay the money.

“Explain to them why you believe in the enterprise and why it will succeed. Make it clear that there is no guarantee it will succeed and there is a financial risk involved. Don’t request more than they can afford to lose as losing it is a realistic possibility and you don’t want close personal relationships to suffer permanent damage.”

—Chane Steiner, CEO of Crediful

4. Have a Repayment Plan

Laying out a repayment schedule and ensuring that the business can generate sufficient funds to make payments is good practice for any form of financing, but it’s even more important for friends-and-family loans. Having this plan can reassure investors before they commit any money, and is a great test for the business owner to consider overall financing costs before taking a loan.

“Friends and family are great when you have a clear path to payback but can’t get great terms with traditional financing. It’s always best to approach friends and family for advice instead of an ask as that puts them in an awkward position.”

—Jordan Hollander, Co-founder of Hotel Tech Report

5. Make Sure There Is an Interest Charge

It’s tempting for entrepreneurs to raise money from friends and family in the form of a gift or worse, an interest-free loan. This is unnecessary and will cause a tax liability that reduces the amount of capital while providing no major benefit to the entrepreneur. The federally-mandated imputed interest rate for short-term loans fluctuates but is low and much better than paying taxes on a gift or loan. If lenders charge a rate lower than the imputed rate, the IRS will tax the loan at the imputed interest rate, creating a tax liability.

“The federal rate for a short-term loan is the minimum lenders charge to avoid a gift tax. If the lender doesn’t charge at a minimum this interest rate, they may have to pay taxes on unearned interest.”

—Jared Weitz, CEO, and founder of United Capital Source Inc.

6. Hire an Attorney

Business owners that raise money from friends and family should use an attorney to help finalize the details. An attorney can ensure that they discuss every point of potential dispute in advance, that they file all paperwork, and that both parties understand their rights and obligations. Skipping an attorney is a big risk and represents one of the most common errors made by entrepreneurs.

“Always have an attorney to draft formal written documents to identify all the terms and risks of each financing to each of your investors regardless of their relationship to you. All financing terms with family and friends have to be supported by financing terms from your business with an unrelated third party. Raising capital for your business is not a do-it-yourself project.”

—Dixon Gardner, Manager at Madison Law

Alternatives to a friends-and-family loan

Business owners and entrepreneurs should know that there are several alternatives to seeking a friends-and-family loan. A quicker funding option for growing businesses is a credit card or online business loan. Founders looking for startup capital should explore the opportunity of using their retirement savings with a Rollover for Business Startups (ROBS).

Alternatives to friends-and-family loans include:

Gift From Friends and Family

Family members and friends may be in a position to offer entrepreneurs a gift instead of a loan. The IRS limits these gifts to $15,000 before tax implications set in, as of 2019. For entrepreneurs needing a small amount of capital, this may be a great option for funding with few drawbacks. However, like friends and family loans, business owners should consider the impact of a gift on personal relationships and disclose the risks clearly.

Business Credit Cards

Business owners rely on business credit cards to finance their day-to-day expenses because they are convenient, easy to manage and offer perks and rewards. The best business credit cards offer business owners miles, points, and cashback on regular purchases, which can cause significant savings for the business and doesn’t require filing a bunch of reports.

Online Business Loans

Online business loans have increased the accessibility of short-term capital for small business owners. They have done this by lowering the time to get funding to one day and reducing the minimum qualification requirements. Business owners can explore options from business loan brokers but should know APRs average around 50%.

Rollover for Business Startups (ROBS)

Franchise and startup founders access their retirement savings with a ROBS to fund their ventures. There are several ROBS providers that offer to work through all the paperwork and that there is no need to take on debt. The benefit for business owners is their ability to control the equity without going into debt or paying extensive fines.

SBA Loans

Traditional banks and some online brokers offer SBA startup loans, which business owners can receive to invest in their business. However, there are caveats, like the long funding times which can take up to three months and the high minimum requirements. However, these loans offer repayment terms up to 25 years with low interest rates and funding up to $5 million.

Pros & Cons of Raising Money From Friends and Family

Raising money from friends and family with equity or debt is simpler, more accessible, and less costly than other financing options. However, it has the potential to impact personal relationships, which can be difficult to plan for because the timeline is often unclear, and can create misunderstandings if rushed.

Pros of Raising Money From Friends and Family

Pros of raising money from friends and family include:

• No minimum requirements to meet: Unlike banks and alternative lenders, friends and family won’t require business owners to go through a credit check. This can be a huge relief to business owners that cannot access other forms of financing due to poor personal credit.
• Accessible at all business stages: Established businesses have many funding options for working capital, but newer businesses often struggle, if they have little to no revenue. This is one advantage of raising money from friends and family because it’s funding that any business owner can access.
• Lower borrowing costs than traditional lenders: Most friends and family members don’t have the overhead that banks do or access to competing investment opportunities. This means they are happy to offer funds at a lower interest rate than most lenders, reducing costs for the business and increasing the chances of success.

Cons of Raising Money From Friends and Family

Cons of raising money from friends and family include:

• Potential to affect personal relationships: Borrowing money from a friend or family member and being unable to pay it back can damage a relationship. Borrowers should also consider that if their business becomes successful, it can cause resentment.
• Unpredictable funding times: Whether raising friends and family funding takes 15 minutes over coffee or three months of meetings is often unpredictable. This means friends and family money may not be the best route for entrepreneurs facing an emergency or other near-term funding needs.
• Large risk of misunderstanding: Rushing into an agreement and failing to define terms can create conflicts and misunderstandings. Borrowers should define what happens if the business defaults, what each party is bringing to the table, and how they will handle conflicts.

Raising Money From Friends and Family Frequently Asked Questions (FAQs)

Do friends and family investors need to be accredited investors?

Friends and family investors that are offering to purchase equity may need to be accredited investors because by purchasing equity they are providing an implicit company valuation. However, a friends-and-family loan doesn’t have this requirement, because it doesn’t rely on company valuation.

Do I have to pay taxes on a loan from a family member?

There is no need to pay taxes on a loan from friends or family members, as long as the loan carries interest. The IRS annual tax-free gift limit is $15,000 from individual family members. Anything over this amount is taxed, so it’s best to charge interest on a friends-and-family loan.

Can I lend money to a friend and charge interest?

Lending money to a friend and charging interest is the wise thing to do. Giving up the immediate use of the money has an implicit opportunity cost, and interest compensates for that cost. Also, by charging the applicable federal rate lenders ensure that the IRS won’t consider it a gift and require tax payments.

Bottom Line

Asking for a friends-and-family loan or raising money from friends and family for equity in a startup is an important step to getting a business the liquidity it needs to succeed. This funding requires some legwork, a presentation, and some paperwork to secure. It offers the benefit of accessibility but presents a large risk to personal relationships.