SCORE Minnesota

Securing Start-Up Capital In Tough Times

November 8, 2009

Securing start-up capital in this tight credit environment causes many start-ups to turn to alternative sources. Friends and family are an invaluable source of support for the aspiring small business owner.  And often, they’re an invaluable source of financial assistance as well.

In fact, more small businesses rely on loans from friends and family than any other funding source.  Familiarity with the person and his/her business goals, the investment opportunity, and the ability to monitor the venture’s progress are among the major reasons why friends and family members willingly contribute to a start-up or expansion.

As Mark Goodman, SCORE counselor from Chicago, explains in the short video interview below, this tight credit environment has caused many small business start-ups to return to the way start-ups were financed decades ago – as a family venture.

However, it is important to bear in mind that a ready source of cash is not without its potential pitfalls.  Business loans from family and friends can also lead to disaster if they are not handled correctly. Unstructured or loosely structured financing and payback terms can haunt both sides later on. Research shows that 14 percent of business loans from family and friends go into default, compared to about one percent for bank loans.

To increase the odds of success, approach family and friends with a detailed proposal, including a professional business plan with financial projections for your business, just as you would a bank or venture capitalist. Be frank about the risks. If things go badly, they could lose all or some of their money. Consider the consequences to your relationships of a soured business deal.

Choose a financing structure that works best for your business and make certain everyone understands it. Specifically, be clear on whether the deal involves an ownership stake in your business, or whether it is a simple debt you plan to repay.  And be clear about repayment terms.

The upside of offering an ownership stake is that your start-up will not be saddled with debt that must be repaid (lower overhead). The downside is that you will need to share profits with your shareholders. Structuring a loan means you are not required to share profits but you will have to repay the loan based upon the terms to which all parties have agreed.

The idea that because the funds are coming from family and friends, it can be done with only a handshake (“a gentleman’s agreement” as they say in the south), opens the door for misunderstandings and hard feelings. And, if there is any group of people with whom you should avoid having misunderstandings and hard feelings, it is friends and family.

Documenting the terms of your agreement in a proper legal format is crucial. You can find downloadable legal documents, including many different Promissory Note variations, at www.findforms.com.  Legal publisher Nolo and LegalZoom also offers loan forms and related information at www.nolo.com and www.legalzoom.com respectively.

Another helpful resource is Virgin Money at www.virginmoneyus.com, previously known as CircleLending.com before it was acquired by well-known entrepreneur Richard Branson.  Virgin Money helps small business owners avoid the problems that can arise with loans from friends and family by providing loan administration, recordkeeping, payment processing and structural support.  The service emphasizes flexibility to meet the needs and concerns of both borrowers and lenders, from terms and interest rates to repayment strategies.

To learn more about financial issues facing your small business, contact SCORE by clicking the link on the right to the office nearest you or click here to request free face to face counseling and/or mentoring.

Mike Clough, St. Paul SCORE
View more posts by Mike Clough

Filed under: Capital,Financial,Start-Up

Tags: borrowing from friends and family, download free documents, findforms, gentleman's agreement, legalzoom, nolo, score, start-up capital, virgin money