Putting It on Paper

Now it's time to put the loan in motion. First, you must state exactly how much money you need, what you'll use it for and how you'll pay it back. Next, draw up the legal papers-an agreement stating that the person will indeed put money into the business. Too frequently, small-business owners fail to take the time to figure out exactly what kind of paperwork should be completed when they borrow from family or friends. Unfortunately, once you've made an error in this area, it's difficult to correct it.

Your loan agreement needs to specify whether the loan is secured (that is, the lender holds title to part of your property) or unsecured, what the payments will be, when they're due and what the interest is. If the money is in the form of an investment, you have to establish whether the business is a partnership or corporation and exactly what role, if any, the investor will play in the business. To be sure you and your family and friends have a clear idea of what financial obligations are being created, you have a mutual responsibility to make sure every one is informed about each step of the process and decide together how best to proceed.

Most important, says McKeever, "outline the legal responsibilities of both parties and when and how the money should be paid back." If your loan agreement is complex, it's a good idea to consult your accountant about the best ways to structure the loan (see "Taxing Matters," below). Whichever route you take, make sure the agreement is in writing if you expect the agreement to be binding. "Any time you take money into a business, the law is very explicit: You must have all agreements written down and documented," says McKeever. If you don't, emotional and legal difficulties could result in squabbles that end up in court. And if the loan isn't documented, you may find yourself with no legal recourse.

Content Continues Below

Even with every detail documented, your responsibilities are far from over. Don't make assumptions or take anyone for granted just because they're friends or family members. Communication is key. If your relative or friend is not actively involved in the business, make sure you contact them once every month or two to explain how the business is going. "It's important to take the time to keep them informed."

And, of course, there are the payments. Though friends or relatives who invest in your business understand the risks, you must never take the loan for granted. "Don't be cavalier about paying the money back," McKeever says. "That kind of attitude could ruin the relationship."

From Start Your Own Business: The Only Start-Up Book You'll Ever Need, by Rieva Lesonsky and the staff of Entrepreneur Magazine (Entrepreneur Press)