Getting a term loan from a bank or the SBA is considered the “traditional” option for small business loans, but according to a study by the University of Michigan, friends and family is where most entrepreneurs get their startup capital. The reason is simple: friends and family loans come with generous terms and typically don’t put your small business in a straightjacket.
But be careful. A friends and family loan can run into two big problems. The first is obvious: if not setup correctly, friends and family loans can damage your relationships with your friends and family. The second is less so: if not setup correctly, friends and family loans can land you in hot water with the IRS if they’re classified as a gift.
Luckily, you can help avoid both these problems by structuring your friends and family loan properly, and documenting that structure. So here are three tips:
1. Get a Formal Contract
Just like when you get a small business loan from a bank or the SBA, friends and family loans should have a written contract plaining stating the amount your small business is borrowing, the interest rate, the payments schedule, and other terms. Also, make sure to write out exactly what will happen if you default. This will significantly reduce the chance of misunderstandings down the line.
But unless you’re a lawyer (and sometimes even if you are…) resist the urge to write your own business loan agreement. These are complicated documents with many traps for the unwary. Does it have a waiver of notice of acceleration? A usury savings clause? If not, your cocktail-napkin business loan agreement may get you (or your friends and family) in trouble.
The best course of action is to involve a lawyer specializing in business loan agreements (or a legal service that does the same). Barring that, there are great sample business loan agreements and step-by-step guides online.
But please note: Some states prohibit making any loan, even a business loan, without a license. So make sure to check any appropriate laws.
2. Create a Payment Plan
Come up with a payment plan. Determine how much money you can afford for each payment, and then make sure that amount is acceptable to your friend or family member. You can also decide on the frequency of payments, whether there are any interest-only or no-payment periods, as well as a fair interest rate.
Two notes about interest:
(1) Don’t forget to amortize the principal in the payment schedule, or else you might accidentally violate state usury laws! If you charge a fixed amount of interest on a declining principal, the interest rate will actually go up over the life of the loan, pushing you above your state’s maximum allowable interest rate. This is particularly important in states with relatively low usury rates on commercial loans like California, New York, and Texas.
(2) Don’t forget to charge at least some interest! If you don’t charge any interest (or not enough interest), you’ll run into taxation trouble. The minimum allowable interest rate depends on the term of the loan, but a good rule of thumb is keep it above 2%.
To make this process easy, use an online tool like the Able Start calculator to create a free payment schedule.
3. Have a Loan Servicer
The biggest problem with friends and family loans is how to handle payments. Unless you’re a star at organization and paperwork, you’ll probably forget to make a payment here or there. Or maybe you can’t make a payment on month. That can make for an awkward Thanksgiving. Don’t force your friends and family become debt collectors. (And note: if they opt to just forgive your debt, they might incur gift tax liability.)
Do everyone a favor and get the help of a loan servicer that can make it easy for you to pay the loan according to the agreed upon terms. This way, the person who loaned you the money for your small business will feel more confident that you’ll repay the loan on time (it will also make the fundraising easier). Plus, you won’t get that awkward feeling that comes with friends and family members asking you when you’ll have their money.
Note: Check with Any Other Lenders First
If you have an existing small business loan, make sure to check with your lender before taking on any new debt. Almost every small business loan prohibits you from taking out additional debt without the lender’s prior written consent. Even a small friends and family loan can trigger an event of default, which would allow the lender to call your loan.
Pro Tip: Amplify the Effect of Your Friends and Family Loan
If you’re thinking about getting a friends and family loans for your small business, consider using Able to unlock up to 9 times as much money at a significantly lower rate.