Borrowing from Family and Friends: Do’s and Don’ts

Elizabeth Millard -- Expert Business Source, 2/28/2007 6:12:00 AM

They believe in your business vision, offer their guest rooms during holidays and vacations, and have finally stopped the teasing about how dorky you looked at the prom. No doubt about it, family and friends can be powerful allies in life – and for your business.

Borrowing money from the ones you love can be an efficient and effective way to fund or grow your venture. But there’s also high risk involved in such an arrangement, with the potential to damage not just your business relationships, but your personal ones as well. Here are some tips for ensuring that friends, family and financing make a good mix:

DO: Write a formal promissory note.

The lenders may be family and friends, but when money is involved, formal paperwork is required, according to Fred Steingold, co-author of “Legal Guide for Starting and Running a Small Business.” Setting down the terms of a loan in writing, and having both parties sign, significantly reduces the potential for a misunderstanding. “A loan agreement, even if it’s just laying out how much was borrowed and when it will be paid back, protects both sides,” notes Steingold.

DON'T: Present your request casually.

Much like explaining the business to an investor, a borrower should put together a short presentation for family and friends. Asheesh Advani, founder and CEO of CircleLending, a Cambridge, Mass., company that assists entrepreneurs with private loan transactions, dubs it the “kitchen table pitch.” The meeting doesn't need to be quite as formal as what's presented to venture capitalists, but that doesn’t mean you should ask for a large sum of money between dinner and dessert. The loan is for professional reasons, so talk about business goals, market competitiveness, and potential risks. Create a level of excitement about the business in friends and family that matches your own, Advani recommends.

DO: Create a workable repayment plan.

It’s a common scenario: Borrowers borrow money and promise to pay it back in three years, and then face a dreaded lump-sum payment at the end of the agreement, says Advani, author of the book “Investors in Your Backyard.”

“It’s very dangerous to structure a lump sum repayment,” he notes. “Instead, focus on gradual repayment over that same timeframe, even if it’s paying only a few hundred dollars a month.”

DON’T: Gloss over the risks.

Every business has potential pitfalls, such as increased competition, unexpected cash flow problems, or employee turnover. Talking only about the positive aspects of your business when asking friends or family for a loan does a disservice to those who are willing to lend money, Steingold says.

“Even if the business fails, the borrower still has an obligation to pay back the money,” he says. “So, even if you're optimistic going in, take some time to be realistic about what could happen and how that would affect the loans.”

DO: Go beyond the usual suspects.

When Ahmet Ertegun wanted to start Atlantic Records, he borrowed money from the family dentist. Sam Walton, founder of Wal-Mart, asked his father-in-law for funds.

“Think broadly,” says Advani. “Many people have a narrow definition of family and friends that usually include parents, siblings and maybe an uncle. But they should be thinking about everyone they know, and beyond.”

Advani recommends putting together a packet of information and giving it to friends and family to circulate. Advani himself has had a great deal of success with the tactic. “You won’t believe who people know,” he says. “And those people could be the next to lend you money.”

Elizabeth Millard is a freelance writer based in Minneapolis.