Business financing and funding is one of the biggest issues that keep founders and entrepreneurs awake at night. Many founders tend to avoid traditional bank loans because of what might be considered unrealistic requirements and unfavorable terms. Of course, there are other interesting ways to get funding for your business even if you don’t want to take the conventional bank loan.
For instance, you may want to consider factor invoicing, accessing a business line of credit, or getting advances on future sales. Borrowing money from friends and family members is one of the ways you can raise funding for your business. However, borrowing money from friends and family looks simple on the surface but it has the potential to sour your business and personal relationships. This piece looks at how to borrow money from your F&F without drawing bad blood down the road.
1. Know how much you need
The first step towards borrowing money from family and friends is to know how much money you actually need to borrow for your business. For instance, if you borrow $3,000 today with the promise to pay back in two months and you suddenly realize that you need to borrow an additional $5000 – you’ll most likely be unable to repay the initial $3000 and your business financing needs will still remain unsolved.
Knowing how much you need also helps you to limit your borrowing to single lump sum or a few sizeable loans. If you need $10,000, it’s in your best interest to owe two people $5000 each than to owe twenty people $500 each. You also need to know exactly what you want to do with the money and you should have a clear-cut idea of how you intend to pay back the loan.
2. Prepare the legal papers
When you borrow money from friends and family, you’ll need to treat the loan like an actual business loan and draw up a loan agreement. The loan agreement puts into writing how much money you borrowed, how the funds will be repaid in installments, how much time you have to pay back the loan, and how much interest you’ll pay back on the loan.
It is important to have a loan agreement so that there are no misunderstandings about the specifics of the loan. For instance, you need to be sure that the lender knows that the loan is not an investment in your company. If the lender wants to treat the loan as an investment, you’ll need to fine tune the terms on the mutual responsibilities.
3. Pay attention to tax concerns
When borrowing money for your business from your F&F, it’s also in your best interest to pay attention to taxes so that you avoid running into issues with the IRS. Informal or verbal loan agreements will almost always land you in trouble with the IRS because you won’t have the burden of proof to show that the money was not a gift. You should note that the IRS can apply the federal gift tax rules on your loan if you can’t show proof that it was a loan that you intend to repay.
Additionally, any loan you get from family and friends between $10,000 $100,000 must attract an interest rate reflecting the fair market value. Loans without interest will attract the IRS’ attention and you might be subject to ‘imputed interest‘ that forces the lender to pay taxes on the interest supposedly received on the loan.