When you’re running a small business, your friends and family are likely your biggest fans. They may even lend you money if you’re in a dry spot, or a traditional lender rejected your loan application. While financing from family and friends might be an easy way to raise capital, it also comes with some risks for business owners who don’t plan ahead.
Here’s the good, the bad and the ugly about borrowing money from your personal connections.
The Good — Easy to Borrow, Almost Too Easy
If your friends and family are willing to lend you money, there’s a good chance their approval process won’t be as strict as a traditional lender. Your personal contacts may just write you a check, skipping steps in the formal loan process like:
- Asking for a written loan agreement
- Negotiating a fair interest rate
- Checking your business credit score
- Reviewing your business plan to learn how/when you’ll pay them back
So if you’re wondering how to borrow money for small business costs in an informal setting, avoiding shortcuts is your safest bet. You should absolutely create a formal loan agreement, listing the interest rate and payment schedule. This way there will be no misunderstandings over when you’ll pay the money back.
You should also present your business plan, showing how you’ll invest the loan proceeds and when your business income should grow. This will give your friends and family more confidence that their money is in good hands. Putting in this extra work ahead of time prevents future problems, which we cover below.
The Bad — Tax Trouble From Skipping the Formal Loan Process
Without the right documentation, financing from family and friends could lead to a tax headache from the IRS. A legitimate business loan must have fair market terms, meaning an interest rate that someone you don’t know personally would charge.
If you receive a loan with a below-market rate, the IRS could consider part or all of the proceeds as a gift rather than a business loan. If someone gives you more than $15,000, they could owe gift taxes.
In addition, if you borrow more than $10,000, the IRS assumes you’ll be paying interest on the loan, according to Entrepreneur. This is taxable income for the lender. Even if you don’t pay interest, the IRS still assumes the lender should have collected something. The IRS sets a minimum interest rate for loans and taxes the lender as if they received this much. This extra bill could be a nasty surprise for someone doing you a personal favor, which is why you should pay them a fair interest rate.
The Ugly — You Put Your Relationships at Risk
You’ve heard the expression, “Never lend money to a friend because you might lose both.” That’s the biggest downside of financing from family and friends. Everyone is in good spirits when you’re looking to the future and imagining things going well. But how will people react during a slow stretch when you miss a few loan payments? Or even if you end up defaulting on the loan altogether?
That’s why it’s important to keep the entire process formal. By showing your contacts your credit score and business plan, they can appreciate the potential risks of lending you money. Also, by giving them a fair interest rate and following a set payment schedule, you ensure the lender is compensated for the risk.
If you run into trouble repaying the loan, it will certainly be stressful, but taking these steps will help protect your relationships.
Before You Make It Personal…
Business owners typically turn to friends and family after a traditional lender turned them down, thinking their personal connections are the only option for raising money. That’s not the case. Alternative lenders offer small business loans with a much easier approval process. For example, your business could qualify so long as it’s been open for at least a year and has over $150,000 in annual sales.
By working with an official lender, you could avoid the risks involved with borrowing from family and friends. Be sure to consider all your options as you figure out how to borrow money for small business costs.
This isn’t to say you should never borrow money from family and friends for your business. The key is to treat a loan agreement as seriously as any other business deal. That way your personal loan will only lead to good results — and you can skip the bad and the ugly.