If your business is struggling to grow or is going through cash flow issues, injecting some of your own cash from your personal finances can help ease your concerns. Small businesses, entrepreneurs, and startups could avoid having to go through a complicated loan process (while wondering if their credit is good enough to qualify).
However, lending money to your business isn’t as simple as writing a check. You’ll need to follow the right procedures, as well as consider what might happen if your business can’t pay you back. In this article, we’ll discuss what to know before you lend money to your own business, the pros and cons, and what to think about before borrowing from friends and family.
How to Provide a Personal Loan to Your Own Business
Here are five things to think about before acting as a creditor to your own company:
1. Know the difference between a loan and an investment
Investing your own money into your business is common among small business owners. Your investment would be considered owner’s equity, and neither you nor the business would generally have to worry about explaining the transaction.
What’s more, you can withdraw the cash at any time — without any tax consequences. At the same time, you may lose some or all of your equity if your business fails.
With a loan to your business, it may require more paperwork, and you may have to work with a tax professional to do it right. But you can also write up the loan agreement to protect your personal interests.
2. Make it official
Without the proper paperwork, it can be difficult to explain what happened to the IRS in the event of an audit, or to future investors and lenders who might question the loan.
As such, it’s generally a good idea to draw up a contract, potentially with the help of an attorney, to make sure the loan and its terms are official. In other words, treat the transaction like any creditor would, despite your standing as the business owner. It needs to be clear that the loan is a binding agreement.
3. Learn about tax implications
Depending on how your business is structured, it could affect you when you file your taxes for the year. For example, a loan could increase your basis in the company.
An increased basis could increase how much you’re personally liable if the company goes under or affect your ability to take losses from the business.
Also, you may need to claim interest, paid or unpaid, as income on your tax return. As a result, it’s crucial that you speak with a tax professional before drawing up the loan to find out exactly how it will affect your taxes and whether you should limit how much you loan your business.
4. Consider making it secured
Whether or not you’re certain things will work out, it may be worth requiring collateral on the loan, such as some of your business’s inventory or equipment.
That way, if your company can’t pay you back or it fails, you can lay claim to some of the company’s assets to get some or all of your money back.
5. Think about other loan options
Lending money to your business can get complicated fast. So, if your business has been around for a while or you have a decent personal credit history, it may be worth looking into other funding options first.
Other common ways of funding your business include:
- Line of credit
- Bank loan
- Equipment financing
- Invoice financing
- Business cash advance
- SBA loans
- Business credit cards
The type of funding you can qualify for depends on your business structure — whether you’re a limited liability company, sole proprietorship, or corporation. A business with any structure can apply for a business credit card, which can help you cover some of your operating expenses as you work through cash flow problems. Some cards even offer an introductory 0% APR promotion, allowing you to finance a large expense over time interest-free.
Qualifying for small business loans and lines of credit may require being an LLC or corporation. Alternatively, U.S. Small Business Administration (SBA) loans could be a good option if you have good personal credit and don’t need the money immediately.
For more on qualifying for better funding options, learn how to establish business credit in this guide from Nav.
The Pros and Cons of Lending Money to Your Business
- Fast business financing
- No dealing with interest rates
- Create your own repayment terms
- Available to new businesses
- Can impact your personal cash flow
- Won’t build business credit score
- Loan amount depends on personal savings and can be limited
- Makes it more difficult to keep personal and business finances separate
Considerations When Borrowing Money for Your Business From Friends or Family
Getting loan money for your business from friends or family can be a sensitive and complex matter. While it might seem like a convenient option, it’s important to approach it with care to protect your relationships and financial interests.
Here are some considerations to make when you’re thinking of borrowing money from friends or family to fund your business:
- Start by having a candid and transparent conversation with your friends or family. Clearly explain your business idea, business plan, financial needs, and how you intend to use the borrowed funds.
- Discuss the terms of the loan, or whether it’s a gift. Make sure everyone is on the same page regarding expectations.
- Keep the person agreeing to lend money updated on your business’s progress, especially if there are changes that could impact the loan or repayment plan. Regular communication can foster trust and goodwill.
Legal and financial advice
- Consult with a lawyer, certified public accountant (CPA), or financial advisor to ensure that the loan agreement is legally sound and protects both parties’ interests. This can help prevent misunderstandings and disputes in the future.
Interest rates and terms
- Decide whether or not you’ll charge interest on the loan. Charging interest can be important for tax purposes and to compensate the lender for the opportunity cost of their money.
- Establish a clear repayment plan with specific due dates and consider what happens in case of a missed payment.
- Draft a formal loan agreement that includes all the terms and conditions of the loan. Include details such as the loan amount, interest rate (if applicable), repayment schedule, consequences of default, and any collateral, if applicable.
- Both parties should sign and date the agreement to make it legally binding.
Business plan and projections
- Provide a well-thought-out business plan and financial projections to demonstrate your ability to repay the loan. This can instill confidence in your ability to manage the borrowed funds effectively.
Consider the impact on relationships
- Understand that mixing business with personal relationships can be risky. Be prepared for potential strain on your relationship with the lender, especially if the business encounters difficulties or you struggle with repayment.
- Figure out how much influence the person will have over business decisions ahead of time.
Collateral and guarantees
- If possible, offer collateral or personal guarantees to secure the loan. This can help mitigate the lender’s risk and potentially lead to more favorable terms.
Alternative funding sources
- Explore other financing options before turning to friends or family. This includes traditional loans, grants, investors, or crowdfunding. Having multiple options can help you negotiate better terms.
- Consider how you will repay the loan if your business does exceptionally well. Discuss whether early repayment is possible without penalties.
- Remember that borrowing money from friends or family can have both financial and personal implications, so it’s essential to treat it as a serious financial transaction.
FAQ’s on Businesses Borrowing From Personal Funds
Can I lend money to my own business?
Yes, you can lend money to your own business. When you do this, it’s typically considered a shareholder loan or a director’s loan, depending on your business structure. It’s necessary to document such transactions properly, including the terms, interest rates (if any), and repayment schedule, to maintain transparency and clarity regarding the loan.
Can I fund my LLC with personal money?
Yes, you can fund your LLC with personal money. Limited liability companies offer flexibility in terms of funding, allowing members to contribute personal funds to the business. This is often done through capital contributions, and it’s a common way to provide initial funding or additional capital to your LLC.
Can I lend money to my business and charge interest?
Yes, you can lend money to your business and charge interest. When you do this, it’s typically considered a loan to the business. To maintain proper documentation and transparency, it’s essential to create a formal loan agreement that outlines the terms of the loan, including the loan amount, interest rate, repayment schedule, and any collateral or guarantees if applicable. Charging interest is common for tax purposes and to compensate you for the opportunity cost of your money. However, make sure that the interest rate is reasonable and in line with market rates to avoid any legal or tax issues. Consult with a legal or financial advisor to ensure that your loan agreement complies with relevant regulations and that it is structured correctly.
How can I legally lend money?
To legally lend money to your business, you can follow these steps:
1. Create a formal loan agreement: Draft a written contract outlining the terms and conditions of the loan, including the loan amount, interest rate (if applicable), repayment schedule, consequences of default, and any collateral or guarantees.
2. Set an appropriate interest rate: If you intend to charge interest, ensure it is reasonable and complies with local usury laws.
3. Document the transaction: Keep detailed records of the loan, including the loan agreement, any communications related to the loan, and all financial transactions.
4. Maintain separation: Keep your personal finances separate from your business finances and clearly designate the funds as a loan to the business.
5. Consult professionals: Consider seeking legal and financial advice to ensure your loan complies with all applicable laws and regulations, as they can vary depending on your location and business structure.
How do I make a personal loan to my own business?
To put personal money into your business, you typically make a capital contribution. This involves transferring personal funds into your business bank account, either as an initial investment or to inject additional capital. You should document this transaction thoroughly, noting the date, amount, and purpose of the contribution.
What is the best way to lend money to my business?
The best way to lend money to your business is by following a structured process. Create a formal loan agreement that clearly outlines the terms and conditions, including the loan amount, interest rate (if applicable), repayment schedule, and any collateral or guarantees. Document the transaction thoroughly and maintain a clear separation between personal and business finances.
What are the benefits of lending money to my own business?
Lending money to your own business can offer several benefits. First and foremost, it provides a direct infusion of capital, allowing your business to meet financial needs, seize opportunities, and cover operational expenses. Additionally, it can help you maintain control and ownership of your business without diluting equity or involving external investors. Depending on the structure of the loan, it may also be a tax-efficient way to manage your personal finances while supporting your business’s growth.