Bankers are not keen on loaning amounts smaller than $30,000. Over half of all small businesses are started with money from friends and family, while others are financed with credit cards. Approximately 10 million people in the U.S. have private loans from people they know.
When you borrow, you are relying on debt financing. There are certain risks and rewards you need to take into account, says Raj Nisankarao, president of the National Business Association (www.nationalbusiness.org), which represents 13,000 self-employed and small enterprises nationwide.
Borrowing from family or friends can provide ready cash, easier terms, and a longer repayment period than traditional sources of debt financing. However, you run the risk of straining family ties. If you do not repay the loan within a reasonable amount of time, you could lose the trust of your family and friends.
Here are some tips to help you avoid common pitfalls:
Set up a formal meeting. Present a well-thought-out business plan or proposal.
Put everything in writing. Draw up a promisory note. You do not need a lawyer to do this, but it is better to seek professional assistance. Every detail of the loan should be addressed, including a payment schedule, what happens if the business is sold, and how the person making the loan will be updated on the business’ progress. Doing so helps eliminate misunderstandings. Also it may prove beneficial should you apply for a bank loan in the future. If you don’t have a lawyer to draw up a contract, check out your local office supply store or Nolo Press at www.nolo.com for a standard promisory note.
Have contingency plans in place. Prepare for the worst scenario, such as bankruptcy or death. For instance, you could add life or disability insurance to the agreement, with the lender as the beneficiary, as a guarantee of repayment.
NBA offers a service to its members through www.circlelending.com, which serves as an intermediary between business owners and their family and friends. CircleLending makes the formal proposal and draws up the promisory note with interest, which could be 0% or 5%, and a repayment plan, whereby money is automatically deducted from your checking account.
According to CircleLending, the default rate of business owners who work with a mediator and develop a structured interpersonal loan is 5% compared to 14% for those who rely on the old-fashioned handshake.