One of the most common ways to fund a small business is to ask friends and family for money. Loans of this type typically have lenient repayment terms and excellent rates compared to other forms of startup financing. However, if you aren’t careful, asking friends or family for financing can come with unintended consequences which can cause both relationship issues and legal problems down the road.
Once you have decided to approach friends and family to finance your business, you’ll want to follow the steps outlined below. While far less formal than getting financing from angel investors, venture capitalists, or a small business loan, the general process is similar.
1. Understand Potential Financing Types
While receiving funding from friends and family can be less expensive than startup business loans or other forms of alternative startup financing, they can also bring unwanted involvement in the business by those providing the funding. Also, you may have tax and legal problems later on if the financing isn’t structured properly.
There are three types of financing possible from friends and family:
- Loans: This is the most common and most clear-cut form of funding from friends and family. They lend you a lump sum of money, which is repaid in monthly installments with interest. No equity is transferred with a loan.
- Equity: You have the option to accept financing in exchange for equity in your business. This may be your only choice if you can’t make monthly payments on a loan. However, it can come with unwanted advice and unrealistic expectations.
- Gifts: Because of potential tax implications, gifts should be avoided. They not only can cause an ambiguous situation where both sides are unsure what to expect but can also be taxed by the IRS and leave you with an unexpected tax liability.
The IRS has an index of applicable interest rates which updates monthly. This provides the minimum interest rates the IRS expects on all loans. If interest isn’t paid on the money invested, the IRS could see it as a gift and tax it accordingly. The required minimum rates listed by the IRS as of March 2022 range from 0.74% (less than three-year term) to 1.61% (up to nine years).
Unless your friends and family are sophisticated investors, taking money as a loan is generally preferred to selling them a share of your business for three reasons:
- Unwanted business advice: Anybody with shares in the business will also want input in the long-term business strategy. This may be less than ideal.
- Potentially unrealistic business valuations: Business owners often overvalue a new startup, giving family and friends an unrealistic expectation of a return on their investment.
- Loan obligations for owners: Selling business shares to family or friends may require them to be personally liable for future financing applications.
2. Develop a Business Plan & Pitch Deck
Prepare a business plan and pitch deck to help answer investor questions and explain why they should invest in the potential of your business. The business plan and pitch deck should show future projections of where your business or product is heading.
A pitch deck should include most of the following information:
- What problem does your product or service solve?
- How is your product or service the solution, and how is the timing is right for your product?
- What the market looks like with current conditions and future growth
- What your product is and testimonials on its value
- How your product or service is performing and how it’ll continue to grow
- Who is on your team?
- Who or what is your competition, and what sets your product apart?
- Three years’ worth of financial projections (ideally)
- Amount of funds needed
If you need some inspiration, Venngage has 30 of the best pitch deck examples, tips, and templates for you to look through. Your pitch deck may not need to be this complicated, but looking through these examples should give you tips on how to present your company’s information.
3. Determine How Much Is Needed
This step occurs concurrent with your pitch deck, as you will include the amount of funds needed in your pitch deck. To determine how much money you need, decide how you plan to use the money. Are you trying to purchase a piece of equipment needed to drive revenue for your company? Are you using the money for initial startup capital? Understand your business needs and use that as a guide to the amount of money needed in startup financing.
Obviously, the more money your friends and family are willing to invest, the better it is for the financial health of your startup. But if they’re willing to invest large amounts of money, there is a good chance they will want ownership in the business instead of lending you money. If they are willing to lend you money, you need to consider the monthly payment required to pay back the loan, and you’ll need to make sure it fits your budget.
Friends and family investments are usually the first steps in funding your startup. Ask for enough that your business can take the necessary steps to grow, but don’t ask for so much that your friends and family might be reluctant to help you. If your business continues to grow, you will likely secure future rounds of funding through venture capitalists or small business loans.
4. Select Potential Backers
Regardless of whether you are asking for funds from non-professional investors such as friends and family, or professional ones like venture capitalists, it is critical to choose investors who meet the following criteria. They should be investors who:
- Have sufficient capital
- Can offer business advice
- Are comfortable with the risks involved
- Have a good understanding of the investment process.
This is the same no matter what type of investor wishes to invest in your company. In many cases, the advice you receive from experienced investors can be more valuable than financial assistance. Those investors can also help you network with other investors, which can help with subsequent, more professional funding rounds.
5. Pitch Friends and Family
Once you have a backer in mind, it’s time to pitch your business. Rehearse your pitch so you’re comfortable speaking about your company to others. The pitch shouldn’t take more than 10 minutes and should cover operating history, opportunity, and the amount of funding needed. Once you finish, ask for feedback so the process can become a conversation. This will help both sides work through any questions and, hopefully, work toward a funding agreement.
6. Negotiate and Prepare an Agreement
Once you have a potential backer, it’s time to hammer out an agreement. Listed below are some of the items you should consider during the negotiation process:
- Choose a financing type: As mentioned above, loans are preferred. If you choose equity or gifts, understand the issues involved with each.
- Set rates and terms and have a repayment plan: This is what you would see in any note signed at a lending institution. You can use a regular promissory note, a simple agreement for future equity (SAFE) for equity transactions, or a keep it simple security (KISS) for either debt or equity transactions.
- Set specific goals and focus on execution: By defining the purpose for fundraising and setting attainable goals, your business will continue to grow, and your investors will have confidence in your business. This could lay the foundation for future rounds of funding.
- Explain the risks: Investors should know the risks before investing in your business. They are investing in a startup, which means there is a risk your business might not succeed, and they may not see a return on their investment. Failing to disclose risks could damage relationships between you and your friends or family.
- Make sure there is an interest charge: If you’re receiving a loan, pay interest on it as mentioned above. This avoids tax problems if the money is later deemed a gift. In addition, the rate should be fair to both parties and comply with the IRS Index of Applicable Federal Rates. However, make sure rates aren’t too high, or you might be better off using one of the alternatives to friends and family loans listed in the section below.
- Hire an attorney: While you might think this unnecessary because you’re working with friends and family, it becomes more necessary. This helps both sides make sure their interests are protected and can help to preserve relationships if the business fails.
Alternatives to Friends and Family Loans
If you’re unable to secure funding from friends and family, or you are looking for additional sources of startup funding, here are four alternative types of startup funding:
- Rollover for Business Startups (ROBS): Ideal for businesses with owners willing to invest retirement funds of $50,000 or more.
- Small Business Administration (SBA) Loan: Best for businesses with good credit and a solid business plan that don’t need funds quickly. Guidant can help with SBA loans for startups.
- Personal loan for business: Used by business owners with good personal credit who need up to $50,000. LightStream is a good choice for an unsecured loan you can use to finance your business.
- Equipment financing: If you need equipment for your startup business, this can be a good option. Smarter Finance USA offers flexible lending options and competitive rates to startup owners with a credit score of at least 600 who can put a minimum of 5% down.
Asking friends and family to fund your startup business is a very common way to get a loan with an excellent rate and lenient terms. However, it’s crucial to consider other factors when considering a friends and family loan to avoid relationship or tax problems.
With friends and family funding, structure is very important, especially if you decide to give equity in your business in exchange for funding. Be sure to have legal and financial experts available during the process. This will ensure everyone’s interests are protected, obligations are understood, and future relationships are preserved.