Definition: Monies, usually in the form a loan, that a business owner gets from
either family members or friends in order to help finance their
startup or growing business
The most common source of debt financing for start-ups often isn't
a commercial lending institution, but family and friends. It makes
sense. People with whom you have close relationships know you are
reliable and competent, so there should be no problem in asking for
a loan, right? Keep in mind, however, that asking for financial
help isn't the same as borrowing the car. While borrowing money
from family and friends may seem an easy alternative to dealing
with bankers, it can actually be a much more delicate situation and
it's important to be as disciplined as you would be in dealing with
a professional investor. Here are some basic rules:
Treat them as if they were strangers. Forget for the
moment that your investor is a friend or family member. Make it an
"arm's length" transaction, and insist on the same sort of legal
documentation you would prepare if your investor was a total
stranger. Why? Because too many entrepreneurs borrow money from
family and friends on an informal basis. The terms of the loan have
been verbalized but not written down in a contract.
Lending money can be tricky for people who can't view the
transaction at arm's length; if they don't feel you're running your
business correctly, they might step in and interfere with your
operations. In some cases, you can't prevent this, even with a
written contract, because many state laws guarantee voting rights
to an individual who has invested money in a business. This can,
and has, created a lot of hard feelings. Make sure to check with
your attorney before accepting any loans from friends or family. So
if it's a loan, have your lawyer prepare an I.O.U. (called a
"promissory note") for the friend or family member, and don't offer
less than a "commercial" interest rate.
Debt may actually be better than equity. If someone
"lends" you money, you only have to pay it back, with interest.
They can't tell you how to run your company. If someone buys stock
in your business, they are legally your business partner. When in
doubt, make it a loan, and pay it back as soon as you can.
Tie all payments to your cash flow. Try to avoid
obligations with fixed repayment schedules. Consider instead "cash
flow" obligations, in which your investor will receive a percentage
of your operating cash flow (if any) until they either have been
repaid in full with interest, or have achieved a specified
percentage return on their investment.
Consider nonvoting stock. If your friend or family member
insists on buying stock in your company, try to make it nonvoting
stock, so they don't have the right to second-guess your every
management decision.