Tapping Friends and Family for Startup Funds

Q: I'm planning to start a retail boutique. I have some savings but not nearly enough to get the business off the ground, and my credit isn't good enough to get a loan from any local banks. A favorite uncle has offered to give me some money to help me get started. Do I have to do anything "legal," or is it OK to just take the money?

A: With the economy in the grips of a major recession and credit crunch, many entrepreneurs have little choice but to tap friends and family members for their startup capital. But that doesn't mean you should treat them like "friends and family."

Nobody gives you money to start a business. People either loan you money--which you must pay back with interest over a specified time period--or they make an equity investment in your business--buying the right to receive a percentage of your future profits. Without proper documentation, there's no way of knowing whether your uncle is making a loan or an investment. If your business becomes successful, he will want a piece of the action. If your business fails, he will want his money back with interest.

If neither of you cares about the structure, consider making it a loan--to your company (corporation or LLC), not to you personally--due five years from now. Charge a fair rate of interest (currently about 3 percent per annum), and make sure the loan can be prepaid "at any time, without premium or penalty." That way, if your business is successful, you can pay your uncle back sooner than he expects, while if your business fails, he can write off the loan as a "bad debt." As a lender, your uncle won't have any legal right to manage your business or second-guess your decisions (which he will have if he makes an equity investment). A business attorney can draft a "promissory note" (a business IOU) documenting the loan in about one hour.

Even if your uncle is a terrific guy who sincerely wants to give you money, you should get something in writing--a letter will do--saying that he does not expect you to pay him back at any time. Otherwise, when your uncle dies, the executor of his estate (who may not be such a terrific guy) may insist you pay back your uncle's "loan."