Entrepreneurs have no shortage of tough decisions to make. Hiring, firing, assessing risk, getting financing -- all in a day's work for a small business owner. But one of the thorniest calls to make is whether or not to borrow money for your business from a family member.
It's difficult to accurately measure how many small business owners borrow cash from kith and kin, but one recent Australian study notes the average Aussie snags approximately $2,400 annually from family members.
No doubt, U.S. small business owners need a lot more cash than that. According to a 2009 study from the Ewing Kauffman Foundation, the average cost for a new business startup is $30,000.
Additional data from the U.S. Small Business Administration (SBA) indicates that startup costs are usually earmarked for two big accounting items: expenses and assets. This from the SBA:
- Expenses -- These are the costs for operations that occur during the startup phase, although they will continue throughout the life of the business. Startup expenses include deductible items such as travel, payroll, rent, office supplies, marketing materials, etc. Expenses also include initial organizational costs like legal fees, state incorporation fees, etc. You can write off up to $5,000 in business startup costs and another $5,000 in organizational expenses in the year that you start a business.
- Assets -- Also known as capital expenses or expenditures, these are the one-time costs of buying assets such as inventory, property, vehicles, or equipment as well as making upfront payments for security deposits. These startup assets don't usually qualify for deduction, however, some can be written off through depreciation at tax time.
To cover those expenses and assets, you just might need to hit Uncle Bernie for some dough, or go to Mom and Dad, hat in hand. What's your best move, if that's the case for your small business?
Let's look at some options:
Formalize the Process
Short of bringing a lawyer into the loan deal (and that's not a bad idea), formalize the process by having a broker structure the agreement, and the money flowing back and forth between two family parties. Companies like Prosper.com and Virgin Money can broker your small business family loan and help keep emotion out of the deal.
Keep It Professional
When you prepare your case for a loan, treat the lender -- even if it is Mom and Dad -- like actual venture capitalists. That means preparing spreadsheets, sales forecasts, revenue models -- all the things you would prepare if you were presenting to an actual bank or venture capital firm.
Achieve Total Transparency
Be open and honest with what you're going to do with the loan money. If you start hiding your reasons, or block any potential negative aspects to the loan, you're going to make the mistake of bruising family feelings, and can potentially trigger rifts that may takes years to overcome.
Go for the Minimum
Your chances of getting a loan are higher if you aim lower. Figure out the absolute minimum amount of money you'll need, and ask for that. There are two good reasons for that. There won't be any “sticker shock” to a family member, and the lower the amount, the higher the chances of getting the loan.
Make sure there's something in the deal for your family lender, so go ahead and offer interest of anywhere from 5% to 10% of the deal. A bonus: The IRS views family loans with suspicion, and interest on the loan will keep their prying eyes away.
Also, make sure your family lender is apprised of your progress paying back the loan, and give him or her ample notice if you'll be missing a payment. Keeping things above board and transparent will help smooth the loan process out, and ensure that you'll maintain good, strong bonds with your family -- and your small business.