6 Rules for Borrowing From the Bank of Family & Friends

Over the past couple of weeks, I’ve covered some of the options available to new business owners when it comes to funding a new business venture. Among all of the options available, borrowing money from friends and family probably ranks as the most common way new businesses are funded. For many entrepreneurs, it can seem easier to deal with close friends and family when it comes to asking for money…after all, you are dealing with people that you know well, who support your vision, and want to see you succeed. Plus, terms can be a little more flexible when dealing with people you know well – missing a payment to your family won’t cause problems with your credit score, and they’ll understand, right?

While there are some serious positives for approaching family and friends for money, there are also a number of pitfalls to consider before making your ask. Be sure to go into this situation with your eyes open, and always keep in mind that not only are you borrowing money, but also potentially putting strain on a good relationship if something goes wrong with the loan. Because existing relationships can make the stakes for failure so high, borrowing from friend and family can often be more nerve wracking than asking a bank or other investor for funding.

So, before you call a family meeting, keep these rules of the bank of family and friends in mind.

Rule #1: Know How Much You Need

Before approaching anyone for a potential loan, you need to sit down and decide exactly how much money you need. Be realistic here, and keep track of your notes – it’s possible that those you approach will want some reason for the specific amount of money you’re asking for. Plus, knowing what you need will help prevent your having to ask more than once for money. If your friends and relatives believe you think they are an actual lending institution, they may not enjoy your company as much as they once used to.

Rule #2: Be Careful With Relationships

Again, before you approach anyone for a loan, take the time to sort out whom the most successful candidates for lending money will be. Once you have a list, consider what the consequences could be if things go bad with your loan. Do you have a good relationship with this person? How close are you? Does it make sense for you to ask them for money? And what will happen if the business is a flop – will the relationship survive a failure? If you feel uncomfortable with the possibility of losing an important friendship or family relationship, then don’t ask that person for money.

Rule #3: Really, Make Sure You Know The Person You’re Asking For Money

Once you have your list narrowed down a bit, think a little more about your prospects. Why do you want to ask these people for money? Maybe they have business experience, or maybe they have the resources to not be hurt financially if the business doesn’t start strong. Consider their philosophy on money – are they spenders? Savers? Gamblers? Will loaning money to you put them in a position where they’re uncomfortable, mentally or financially?

This is why it’s a bad idea to ask acquaintances for money – if you’re going into a loan blind, then who knows what bombs they could drop on you while you’re trying to get your business started. Only borrow from people you know and trust.

Rule #4: Keep It Professional

Create a pitch for your family and friends. It doesn’t have to be the same for every person, but it should contain the same information you would provide to a bank or venture capital firm. Show any potential lender that you’ve done your due diligence and have a plan for running a successful business. And if your friends and family have questions about how you’re going to make things work, answer them! You may not think PawPaw has a grasp on new technology, but he does know a thing or two about cash flow, and he’s not going to give you money unless you’ve made him feel like you know what you’re doing.

Rule #5: What’s In It For Them?

When you make your pitch and your ask for a clear amount of money, you’ll need to also provide information on what’s in it for them. In other words, are you looking for a loan that will be paid back with a certain amount of interest, or are you offering a chance for your family and friends to actually own a share of your company? If you’re planning on the latter, how involved do you want your particular friend or family member to be involved in your business? Be sure to manage the expectation of involvement if you’re selling shares – it’s better that you make your wishes known now than to end up with bad blood over a disagreement later.

Rule #6: Make It Official

Congrats! You and your family and friends have agreed on a way to help start your business! Before you go running off with a pile of cash and checks, it is time to make your arrangements official. Terms of the loan or buy-in should be written up and both you and the lender should sign and acknowledge that you have mutually agreed to the arrangement – this includes the lifespan of the loan, rate of interest, and payment amounts. Note that you don’t necessarily have to have the same terms for everyone, but whatever the terms are, the people involved should be clear about what they entail.

The Bottom Line: Borrowing from family and friends can be a great way for new businesses to get the funding they need to get started, but there are pitfalls as well. Know who you plan to ask for money, their financial philosophy, and what they expect in return for their help. Above all, be professional – provide the same information you’d provide a bank, and make sure your final terms are in writing and signed by both you and your lender.

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