It should be no secret in the post-coronavirus world that we should expect to see credit criteria tighten up as many lenders rethink their credit criteria or even step away from small business lending altogether. That’s what happened in the last economic crisis. Fortunately, that’s not true of all lenders and there are still options available for creditworthy borrowers as well as options for small business owners with a less-than-perfect credit history. Borrowing from friends and family is one of those options.
Although borrowing from friends and family isn’t the first choice for most small business owners to look for small business financing, it is perennially one of the best sources for small businesses from the smallest sole proprietorship to larger, more established, small businesses. Although these loans are sometimes referred to as 3-F loans, referring to the friends, families, and fools who offer loans to small businesses, there are a handful of things you can do to successfully pull it off and still get invited to Thanksgiving Dinner.
Here are the 4 things you can do to be successful at borrowing money from friends and family.
- Make it official. In other words, treat a loan from friends and family like you would any other type of financing. Avoid the temptation to be cavalier about making periodic payments. Put in writing the terms of the loan—when payments will begin, how often they will take place, what will the payment amount be, and what will happen if you miss a payment. Even if your family lender doesn’t think this is necessary, it will help you avoid misunderstanding down the road. If your lender is willing to wait until some date in the future (when your business is more profitable, for example) before they accept payments, make sure you define what that looks like. Is a predetermined date in the future or is it a revenue number? Will there be any interest on the loan? Make it part of the terms so there is no confusion down the road and you don’t get removed from the Christmas Card list.
- Be specific about what you need and why. I feel this way about any financing. Identify the need you’re trying to meet and seek the capital to meet that need and no more. I believe the worst answer to “How much money do you need?” is “How much can I get?” The best answer is, I need X amount of money and this is what I plan to do with it—even better if you can add something about what you think that extra money will do for your business. This is particularly true when borrowing from an old college roommate or your wealthy Uncle Fred.
- Be clear about whether you are offering equity, or if it will be a loan. It might be tempting to suggest giving your friend or family member a piece of the pie in lieu of making periodic payments. There’s nothing wrong with doing that, but if that’s the case, you should make it official. Basically, you’re inviting a member of your family to be a minority shareholder in your business. If they happen to be a skilled business person who can help you grow your business with guidance and advice, this could be a really good thing. Just remember if you’re offering them equity, even if they aren’t skilled at running a business, they will likely expect you to listen to their thoughts and advice. Unless you have a friend or relative who really knows his or her way around a small business, it might make more sense to bite the bullet and make periodic payments.
- Communicate. It doesn’t really matter if you are offering equity or borrowing from your Great Aunt, make sure you communicate with her. Whenever my father-in-law would lend money to his kids when they were young, he kept track of it in a ledger and held them accountable. Of course they were children, but he taught them valuable lessons about financial responsibility and communicating when problems arose (which they occasionally did). If you haven’t been regularly communicating with your family lender, you shouldn’t be surprised if they are nonplussed if you’ve missed a few payments and show up at the next family gathering in a new car.
Taking a more formal approach to borrowing from friends and family not only makes it easier for who you’re borrowing from, but formally outlining your objectives is a good exercise for you—regardless of whether you’re borrowing from a family member or banker. An informal exchange might feel more natural, but can lead to unanticipated problems in the future.
Many business owners borrow money from family members with every good intention of repaying the loan, but it’s easy to let those obligations take a backseat to what they might consider more important business obligations. I’d suggest a loan from a family member is every bit as important as a loan from your bank, credit union, or any other lender. In fact, a loan from friends and family has complexity that’s not a part of other business financing and should be treated like “real” financial obligations, because they are. Which is the best way to be successful at borrowing from a friend or family member.
This article was originally written on August 4, 2020.