When he started looking for money to help launch his payroll services business in 2004, Jason Maxwell turned to some familiar faces: friends and family, including his stepfather.
"It was a humbling experience," recalls Maxwell, whose company, MassPay Payroll Services, is located in Beverly, Massachusetts. "So even with my stepfather's loan, I insisted that he be paid interest on the amount he lent me. I also set up an amortization schedule that showed how much principal and interest he'd be paid each month over the three-year life of the loan. From the start, I treated it more like a business transaction than a personal favor, and I know he appreciated that approach."
Borrowing from friends and family is a classic financing tactic for entrepreneurs, but it's also one that's fraught with peril. If things go wrong, you can lose not only your shirt, but also your relationships with the people who are most important to you. Here are six tips for getting it right:
1. Create a sound business plan that shows how the money will be used and how you expect the business to perform. "You want to treat your friends and family with as much respect as you would an institutional investor," says entrepreneur Anthony Kirlew, the founder and CEO of AKA Internet Marketing and one who's used friends and family financing in the past. "After all, they are taking a risk and showing that they believe in you."
2. Put the terms of your deal in writing, and consider having a lawyer draft or review the document. "Our memory is faulty," says Rick Bisio, author of "The Educated Franchisee" and a consultant to prospective franchisees. "A few years from now selective amnesia may set in. This can lead to significant family disagreement when one person says the money should be paid back in two years and the other says it was 'around two to five years.'" Putting the terms in writing, Bisio says, also forces entrepreneurs to think through what they are doing and how they will handle adversity.
3. Set clear repayment terms, or, in the case of equity financing, an exit strategy. If you're getting a loan, you need to decide what rate of interest your lenders will earn, of course, but also when repayment will begin and on what schedule. If you're giving your financiers an ownership stake in your company, you'll need to decide how they'll be compensated for their equity investment and how they can sell their shares — to whom and on what terms — should they wish to do so at some point in the future.
Be clear about spending and profit-sharing plans, too. You may decide, for example, that profits beyond the owner's salary are to be shared pro rata among stockholders. But if you intend to pour everything above your salary back into the business for the first 10 years, your other stockholders need to know that, and buy into it. They may want written assurance of a vote on all major investments over an agreed-upon threshold, and on the sale of any of the business's major assets.
4. Specify what happens if your fledgling business is not able to repay borrowed money. Maybe you will agree to repay the loan from your personal assets over time, with financial penalties. Maybe your friends or family members will agree to assume the risk of losing their investment. Either way, spelling out the terms in advance will help to avoid recriminations later.
5. Keep the lines of communication open. By avoiding surprises, you help to avoid bad feelings among your financiers. "There were a couple of times I needed to defer a payment to my stepfather until the following month, and rather than just pay him later than expected, I made sure to check in with him the moment I knew it might be a possibility," recalls Maxwell. "Again, I know he appreciated that." (Maxwell ultimately repaid his stepfather's entire loan early, in two years rather than three.) Equity investors will probably insist on, and deserve, regular updates on the business's progress, including periodic reviews of profit-and-loss statements.
6. Be creative. Your friends and family may not have enough cash to provide you with funding outright, or they may be reluctant to assume the business risks that you're so eager to take on. That doesn't necessarily mean they can't help. Lindsay Lopez says her parents were able to put money into a savings account that she then used to secure a line of credit from her bank to help her launch Form Pilates, a studio in New York City. As long as Lopez remained current on her payments, her parents' money stayed untouched.
Sourcing money from friends and family can be a great way to get your business off the ground, or to help it reach new levels of success. With careful planning, it can be a win-win deal for everybody.
A former reporter for The Wall Street Journal and Dow Jones and contributor to Barron's, Randy Myers is a contributing editor for CFO and Corporate Board Member magazines.
This story originally appeared on Business on Main