They say that “fools rush in where angels fear to tread,” and the same applies to raising capital for your business from friends and family. The personal relationship should act as an extra warning flag to you that such transactions should not be treated lightly or casually.
When times are hard and other sources of available credit dry to a trickle, friends and family can be a lifesaver. But whether the funds are offered to you—or you affirmatively ask for them—take them with caution. The following tips will help smooth the path and make sure everyone gets a fair deal.
1. Put it in writing. Yes, we’re lawyers, but this is an area where you do NOT want to rely on mentally “being on the same page” as your cousin or sorority sister. Any “he said, she said” disputes will never be “just business.” If anything goes awry, you’ll never stop hearing about it at family (or college) reunions. Also, having certain provisions in writing can prevent wrangling with your “benefactor’s” estate as to whether the sum needs to be repaid.
2. Is it a loan or a gift? Loans and gifts have different tax consequences – and different expectations for how, when, and whether they will be paid back. Decide which it is.
3. If a loan, decide your terms. How long will you have to pay it back? At what interest rate? If possible, tie repayment to cash flow so that you aren’t saddled with even more debt obligations during a financially strapped period. And don’t forget that the IRS may treat some portion of the payment as taxable interest income to the lender (the IRS calls it imputable interest) even if you and the lender don’t.
4. Carefully weigh the pros and cons of debt vs. equity. It may seem like a good idea at the time to give your father a “piece of the action” because you don’t have to repay him in cash. But Dad may take this equity stake as an opportunity to tell you what to do with your company … in a way that might make you wish you had just paid him off . . . and in many cases, as co-owner, he’ll have a perfect right to do so.
“Neither a borrow nor a lender be,” wrote Shakespeare, but, if you must (as most of us do), these tips can help you navigate the potential problem areas in lending and borrowing money from friends and family.