Remember when you were a kid and your parents paid all the bills and told you what to do? Well, if the family business runs into a cash crunch and you need to borrow money, think carefully before borrowing from parents and other relatives — or you could find you stepped into a time warp.
Weighing Equity Against a Loan
Among family members, loans tend to be more popular than equity investments because they are cheaper, limit the lender from trying to get involved in the business and carry a lower risk of losing the entire investment.
For example, let’s say you sell $10,000 worth of stock in your family-run restaurant to your brother-in-law. The business grows, but there is little chance you will ever be able to sell the business or pay dividends. Suddenly, you and your wife decide to pull up stakes, close the business and move.
Legally, this leaves your brother-in-law more than a little frustrated, waiting to get paid for his worthless stock.
If you had taken a loan instead of an equity investment, you could pay him back in installments. Some family borrowers change an equity investment into personal debt if the business fails in order to save relationships and minimize hard feelings among other family members.
You could consider structuring the cash infusion as a shareholder loan in part or in full, with flexible terms.
Before relatives invest, show them a business plan that outlines the risks involved, and encourage them to get a professional, independent opinion.
Prepare a shareholder’s agreement that sets out the possible risks and benefits as well as rights and remedies. This is an essential in maintaining good relationships if things go bad.
Finally, make sure you report to your investors on a candid and regular basis. Report problems that come up. Many investors can accept failure and their financial loss if they know that you have kept them fully and honestly informed and you did your best to make the business work.
For the most part, family loans come with emotional attachments — that’s why it’s sometimes called “love money.” Borrowing from relatives or allowing them to invest in your new business can put personal relationships at risk if you aren’t careful.
In lending money, many relatives or friends assume a high risk with little other reason than doing a favor and perhaps making some money. Showing concern and taking steps to protect their money can go a long way to ensure future cooperation and avoid dissension. Presenting them with a well-thought-out business plan can also strengthen their faith in you.
If your business is feeling a cash crunch and you plan to approach a relative for assistance, here are some tips on how to help minimize the potential resentment and bad feelings:
Put the Arrangement in Writing
If the loan is simple and small, it may be sufficient to write a letter outlining its terms. Beyond that, it’s a good idea to get professional advice. Put everything in writing including the names of all the principals, the date and amount of the loan, the date you will pay the loan in full, dates of individual payments, the interest rate, a promissory note and a list of any collateral.
Have the document witnessed by a notary, not a family member. If the loan is for a particular venture, such as an expansion or starting an additional line of business, write a formal business plan. That can help give them more confidence in your abilities to carry through on the plan and repay the money.
Specific collateral for either co-signers or lenders will ease concerns and ensure that they don’t lose everything if things don’t go well. You could offer certificates of deposits or bonds. A second mortgage on your home, however, might make the lender uncomfortable. A relative isn’t likely to be willing to put you out on the street if things go wrong.
Check Tax Laws
If the loan is not commercial (it doesn’t carry a market rate of interest and repayment terms), the lending relative cannot deduct expenses relating to it. If the loans are not on commercial terms and the business fails, the lender cannot claim an allowable business investment loss.
Know the Lender
Analyze your relationship with the person willing to give you loans. What will happen to the relationship if you lose the money or are unable to repay the loan? If the person cannot afford to lose money, it’s best not to approach them. You can also put relatives in a tough spot if they have to turn you down, creating hurt feelings all around. When you ask, be prepared to handle a refusal graciously.
Keep it Open
Tell other close relatives about the arrangement. Family secrets can be hard on everyone. Keeping other family members informed about the loan can help reduce friction, jealousy and feelings of favoritism. The arrangement should make business sense to all involved, particularly those in the business.
Be honest with family lenders about what they’re getting into. The motives for lending money can range from altruism to greed. Make a list of the relatives or friends you could approach for a loan and list their likely motivations. Parents generally have different reasons for investing than uncles do. Tailor your pitch to each individual.