What You Need to Know About Funding Your Business Through Friends and Family Read this before you approach friends and family to finance your new business.

In their book Start Your Own Business, the staff of Entrepreneur Media Inc. guides you through the critical steps to starting your business, then supports you in surviving the first three years as a business owner. In this edited excerpt, the authors discuss the basics of financing your startup with money from friends or family.

After self-financing, the second most popular source for startup money is composed of friends, relatives, and business associates. It makes sense. People with whom you have close relationships know you're reliable and competent, so there should be no problem asking for a loan, right? While squeezing money out of family and friends may seem an easy alternative to dealing with bankers, it can actually be a more delicate situation.

To help with the process, first approach the person you'd like to borrow money from in an informal situation. Let them know a little about your business to gauge their interest.

If the person seems interested and says they'd like more information, make an appointment to meet with them in a professional atmosphere. "This makes it clear the subject of discussion will be your business and their interest in it," says Mike McKeever, author of How to Write a Business Plan.

During the meeting, plan to show this person your business plan. Explain the plan in detail, just as you would with a banker or other investor. Your goal is to get the other person on your side and make them as excited as you are about the possibilities of your business.

As you discuss the loan, try to separate the personal from the business as much as possible. "It's important to treat the lender formally rather than casually passing your request off with an "If you love me, you'll give me the money' attitude," says McKeever.

Be prepared to accept rejection gracefully. "Don't pile on the emotional pressure—emphasize that you'd like this to be strictly a business decision for them," says McKeever. "If relatives or friends feel they can turn you down without offending you, they're more likely to invest. Give them an out."

Once they agree to loan you money, it's time to put the loan in motion. First, state how much money you need, what you'll use it for, and how you'll pay it back. Next, draw up the legal papers—an agreement stating that the person will indeed put money into the business. Too frequently, business owners fail to take the time to figure out exactly what kind of paperwork should be completed when they borrow from family or friends.

"Small-business owners often put more thought into figuring out what type of car to buy than how to structure this type of lending arrangement," says Steven I. Levey of accounting firm GHP Financial Group. Your loan agreement needs to specify whether the loan is secured (that is, the lender holds title to part of your property) or unsecured, what the payments will be, when they're due, and what the interest is. If the money is in the form of an investment, you have to establish whether the business is a partnership or corporation, and what role, if any, the investor will play. To be sure you and your family and friends have a clear idea of what financial obligations are being created, you have a mutual responsibility to make sure everyone is informed about the process and decide together how best to proceed.

Most important, says McKeever, "Outline the legal responsibilities of both parties and when and how the money should be paid back." If your loan agreement is complex, it's a good idea to consult your accountant about the best ways to structure the loan.

Whichever route you take, make sure the agreement is in writing if you expect it to be binding. "Any time you take money into a business, the law is very explicit: You must have all agreements written down and documented," says McKeever. If you don't, emotional and legal difficulties could result that end up in court. And if the loan isn't documented, you may find yourself with no legal recourse.

Putting the agreement on paper also protects both you and your lender come tax time. Relying on informal and verbal agreements results in tax quagmires. "In these cases, you have a burden of proof to show the IRS that [the money] was not a gift," says Tom Ochsenschlager, vice president of taxation for the American Institute of Certified Public Accountants. If the IRS views it as a gift because there was no intention to repay it, then the lender becomes subject to the federal gift tax rules and will have to pay taxes on the money if it is more than $14,000 as of 2014. Also make sure the person providing the money charges an interest rate that reflects a fair market value.

To be absolutely safe, Ochsenschlager recommends you make the person providing the money one of the business' shareholders. This effectively makes the transaction an investment in your company and also makes it easier from a tax standpoint for your friend or relative to write off the transaction as an ordinary loss if the business fails. (This applies only if the total amount your company received for its stock, including the relative's investment, does not exceed $1 million.)

Making your relative a shareholder, however, doesn't mean you'll have to put up with Mom or Pop in the business. Depending on your company's organizational structure, your friend or relative can be a silent partner if your company is set up as a partnership, or a silent shareholder if you are organized as an S corporation or limited liability company.

But even with every detail documented, your responsibilities are far from over. Don't make assumptions or take people for granted just because they are friends or family members. Communication is key. If your relative or friend isn't actively involved in the business, make sure you contact them once every month or two to explain how the business is going. "It's important to take the time to keep them informed," says McKeever.

And, of course, there are the payments. Though friends or relatives who invest in your business understand the risks, you must never take the loan for granted. "Don't be cavalier about paying the money back," McKeever says. "That kind of attitude could ruin the relationship."