Pitfalls of Business Financing That's "All in the Family"

Enjoy the flexibility of loans from friends and relatives, but with the same professional approach you use with your banker.

Carole is a young woman who was downsized from her position as an event planner with a major hotel. Because she loved the job she had and possessed a real passion for working in this field, she decided to capitalize on her skills and contacts by starting her own home-based event planning business.

The one thing Carole didn't have was money. She didn't need much—only about $5,000—but a recent auto purchase had used all her ready cash. After making a few calls and doing some research, Carole quickly realized her funding wasn't going to come from a commercial lending institution. On the advice of a friend, she decided to turn to family.

She mentioned her situation to several family members, and before long, her brother-in-law showed some interest. Carole filled him in on her plans, her potential contacts and her dreams for some day being one of the major event planners in the area. Her enthusiasm was contagious and her brother-in-law agreed to lend her $5,000. They shook hands and Carole promised to pay him back when the "big events" came along.

Carole's first year in business was excellent, but there weren't enough funds to make any payments. During her second year, many clients experienced budget cuts and eliminated non-essential meetings and events. Her business struggled just to make ends meet. Again, no payments were made. By year three, Carole could see the handwriting on the wall: her business wasn't going to make it.

Carole's brother-in-law became increasingly impatient. Months went by with no attempts at repayment. Threats, messages and letters received no response. Conversations resulted in shouting matches or tears. Carole finally closed up shop and found employment in a corporate setting.

Since she considered her business a failure, Carole ultimately didn't see the need to repay her brother-in-law. Her attitude was, "I risked my money and lost it—he did the same." Family relationships were damaged as a result.

Although borrowing money from friends and relatives can be risky, the Federal Reserve Board notes there are over seven million loans between individuals outstanding at any given time in the U.S.

If you are borrowing from family or friends, consider the following tips:

Make the proposal professional.
Put together a cohesive loan request just as you would for a banker. Present the proposal in a business-like manner, including financial statements, projections and tax returns.
Document the loan terms.
Handshakes are never enough. Relationships can be ruined due to misunderstandings about loan terms. Put everything in writing, stating exactly how much you will be borrowing, how it will be used and how you plan to pay it back. Be specific about payment dates and interest rates. Your agreement should also specify if the loan will be secured (that is, will the lender hold title to part of your property?). You may want an attorney to prepare a promissory note or other legal document.
Use a fair interest rate.
Lenders will be much more agreeable about delaying payments now and then if they feel the interest rate is fair. Contact a bank to determine the current commercial interest rate. The IRS has strong opinions about no-interest loans among family members: Loans made below market rates, or at no-interest, could be subject to federal gift tax.
Carefully plan payment schedules.
Tie payments to your cash flow. Consider using an accountant to help you determine the best way to structure the loan. Avoid balloon payments or lump-sum payments at the end of the loan term—these are risky for both borrower and lender.
Cover your bases.
Consider options such as a life insurance policy that would cover the debt in the event something happens to you before the loan is repaid in full. An attorney can advise you of other "bases" that should be covered depending on your individual circumstances.
Remember the tax benefits.
While it may be tempting to avoid formalizing loans among friends and relatives, there can be tax benefits to using a formal promissory note. If the borrower cannot pay back the full loan amount, the lender is entitled to a tax deduction as "bad debt"—but only if the loan was formalized.

The ability to adjust loan terms, make an occasional late payment and react to shifting circumstances are all advantages of loans made among friends and relatives. However, enjoy this flexibility with the same professional approach you would with your banker: Keep your lenders informed of any changes in your situation as well as your plans for getting back on track.

- Barbara Cunningham, former business specialist, MO SBTDC