5 Steps To Business Financing With Friends Or Family

Managing Your Bottom Line
Magazine Contributor
8 min read

This story appears in the February 1996 issue of . Subscribe »

If the banks won't budge and you've exhausted your savings, your last resort for financing may be your family

Family financing can be a bonus for everyone involved. If your parents, for example, loan you $40,000 to start a business, and you pay them back, with interest, on a regular repayment schedule, you get start-up capital and a deduction for the interest, while the folks earn some interest income.

However, things get much more complicated when a family loan goes sour. Say your start-up business had a great first year, and you repay $10,000 of the $40,000 loan, with interest. But in year two, you lose two major customers and get behind in meeting obligations, and by year three, you have to declare bankruptcy.

You can start another business next year, but what about your parents? If you cannot repay your loan, they are in a double bind with the IRS. Because most parents or relatives are not considered "in the business" of making loans, they are not eligible for a business bad debt deduction which could allow them to deduct the loss fully in the year the debt is determined uncollectible. Instead, they must try to qualify for a non-business bad debt deduction, which is treated as a short-term capital loss. If your parents have no capital gains (such as gains from the sale of stock) to offset a $30,000 loss, they can only deduct $3,000 of the loss in the year it occurred and carry the balance over to future years.

The IRS may say, however, that the unpaid $30,000 was actually a gift and disallow the deduction. While the tax rules allow each of your parents to "gift" $10,000 a year to any individual, the remaining $10,000 could cause your mom and dad to run afoul of some complicated estate and gift tax rules.

How can you avoid this financial fiasco? Make your loan from family or friends as businesslike as possible, so that they qualify for a non-business bad debt deduction in case your start-up never quite gets off the ground. Here's a five-step checklist to follow when you set up a friendly, but professional, loan with your friends or family members:

1. Insist on a note or other evidence of indebtedness.

2. Pay a market rate of interest.

3. Draw up a fixed repayment schedule.

4. Keep accurate records of repayment.

5. Have proof that your business is solvent at the time of the loan or have a realistic business plan that indicates the loan will be repaid on schedule.


As the popularity of warehouse stores shows, consumers know buying in bulk is the way to save money. Now franchisees are putting that concept into practice to help boost their bottom lines.

Franchisee purchasing cooperatives, which combine several franchisees' purchases to maximize bargaining power with suppliers, are still fairly rare. But according to Stanley Dreyer, vice-president of development for the National Cooperative Bank in Washington, DC, they are starting to catch on with more franchise systems.

Though Dreyer has only been in touch with about 20 purchasing co-ops in the country, he notes this number has doubled in the past two years alone. He suspects that more co-ops are operating within franchise systems. Also, Item 8 of the new Uniform Franchise Offering Circular (UFOC) now requires franchisors to disclose more about their supplier relationships. This change in the UFOC "may cause franchisors to take a look at the economic benefits of purchasing co-ops," says Dreyer.

What are those benefits? "It puts everybody on a level playing field as far as getting supplies at the same price," explains Dreyer. "It also dispels the feelings franchisees may have about their franchisors profiting off them; it lowers their suspicions that they're being charged too much for the product." Dreyer also points out that partnerships between franchisees and franchisors via a purchasing co-op allow franchisees to become more involved in purchasing decisions. That benefits the system as a whole, says Dreyer, because "the franchisee knows best which products are really selling and what the general public might want."

Unfortunately, purchasing co-ops are currently offered primarily through the larger fast-food franchise systems, as the overhead costs of running a co-op require a certain volume level. However, as co-ops become more commonplace, Dreyer believes smaller franchisee groups will either be invited to join existing purchasing co-ops or take the initiative to start their own co-ops with other small groups.

Dreyer also predicts that the cooperative concept will expand beyond purchasing to address franchisee needs such as financing. As these changes occur, he foresees "a win-win situation, economically as well as relationally. It will show franchisors and franchisees they're really in this together." -Janean Chun

Confidential Financials

Many start-up entrepreneurs assume that all communications with their attorneys are privileged, but that's not necessarily true. Jerry August, a nationally recognized tax attorney with the West Palm Beach, Florida, firm of August, Comiter, Kulunas & Schepps, P.A., sets the record straight on some common misconceptions of attorney-client privilege.

Q: Any financial information you give to an attorney who uses the information in preparing your income tax return is considered privileged, right?

A: No. Any information contained in a tax return-including the client's supporting documents, records and workpapers-is not privileged, even if a lawyer prepares and files the return.

Q: What kinds of communications between an attorney and a client are considered confidential?

A: In general, if the client seeks legal advice, as opposed to routine tax or business advice, the communication between the client and attorney is privileged. Communications made in connection with the preparation of tax returns, real estate contracts and articles of incorporation, however, would not be privileged.

Q: What's an example of a privileged financial communication?

A: A protected communication would be a client's confession to a tax attorney that the client knowingly left off significant amounts of income on prior years' returns.

Q: What about accountant/client privileged information?

A: For federal tax purposes, no other professional can protect communications. If the client went to a tax accountant or financial planner with a confession of omitting prior years' income, the information would not be privileged because no legal advice from an attorney engaged in the practice of law was involved. In fact, any time a client consults an attorney as a business advisor, agent, friend or in any capacity other than as a lawyer, the communication is not protected.

If you find yourself in a legal bind over financial matters, go to your attorney first. If your attorney needs assistance from an accountant, he or she should contract with the accountant with the understanding that:

A. The accountant is the attorney's agent;

B. Payment will come from the law firm, not from the client; and

C. All schedules and documents will become the sole property of the attorney, and the accountant will keep no copies.

How to Figure Your Break-Even Point

A company's break-even point is the volume of sales at which revenues and expenses are equal. At the break-even point, you have not yet made a profit, but you have generated enough revenue to cover your expenses. Determining the break-even point for your start-up can help you analyze the effects of pricing, volume and costs on your profits.

To figure your break-even point, start by carefully estimating both your fixed and variable costs. Fixed costs are those that don't change with your sales or production. Examples of fixed costs are rent, insurance and equipment depreciation. Variable costs are those that change with your level of sales volume, such as production materials.

Use the following formula to determine at what volume of sales your product will break even:

Price x Volume of Units Sold = Fixed Costs + (Variable Costs x Volume of Units Sold)

Example: Sally Jones plans to make and sell hand-painted t-shirts. She estimates her fixed costs for the year at about $4,000. Each shirt will cost $10 to produce. She has researched the market for hand-painted t-shirts and plans to price hers at $25 apiece.

Using the break-even formula above, she computes:

25(Volume of Units Sold) = 4,000 + 10 (Volume of Units Sold)

15 (Volume of Units Sold) = 4,000

Volume of Units for Break-Even = 67

Based on her analysis, Sally knows that she needs to sell at least 267 t-shirts to break even. In order to make a profit, she will need to sell more than that. The next question Sally must ask herself is "Do I believe I can sell at least 267 tee shirts this year at $25 each?" If the answer is no, she may have to rethink her assumptions about pricing and gauge the effect on her break-even point. -Carolyn Lawrence

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