Loans

The Nitty-Gritty Truth About Loans From Family and Friends

The Nitty-Gritty Truth About Loans From Family and Friends
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Have you heard of FFF money? The FFF stands for family, friends and fools. Many new entrepreneurs receive the initial funding for their businesses from people close to them, causing these relationships to start sliding toward disaster.

Over my 15-year career as an entrepreneur, I’ve borrowed from all three groups. So have many other entrepreneurs.

Money from the FFF group represents the largest source of funding for new startups, according to the "Global Entrepreneurship Monitor 2012 United States Report." While some of these funding arrangements have happy endings, all too many end painfully, with consequences ranging from unfortunate to disastrous.

Before considering FFF money as an easy way to start your business, consider the following:

Related: Think Carefully Before Seeking Funding (Infographic)

1. Money changes people.

Nobody starts out a marriage saying, “How can I use money to ruin this relationship?” But many couples seemingly do. Financial disagreements are the #1 predictor of divorce in the United States, according to one study.

The person you dated and were madly in love with before you married can become another person entirely when finances enter the picture. Money changes people in business relationships as well. Finances will cause contention when there isn’t enough, when there's too much and at every point in between, no matter how great a person you are or the lender is. 

2. The borrower is a slave to the lender.

The day you take a loan from someone, you become that person's slave until you pay off the last cent, many have said. The lender may claim to not mind and that he or she just wants to help you succeed.

But wait until you take a vacation in Hawaii, buy a new house or car or choose a more expensive dish at a restaurant than he or she does. The lender might start thinking, Wait a second, I gave this guy a loan and he’s spending money on this instead of paying me back? 

3. Your business may fail.

Most small businesses do fail. Think yours will be the exception? So did the roughly half of U.S. business owners who shut down their companies within the first five years of doing business.

What’s your plan if your great idea doesn’t work out? Will you feel OK telling investors you’re sorry you lost their money or will you feel obligated to turn investments into loans and pay the person back? In the latter case, what will be your plan for paying the loans off?

Given the risks, what can an entrepreneur do to reduce the chances of a family loan harming a personal relationship?

Recently my father asked me whether he should make a small loan to my nephew in high school who wants to start a music recording studio. Much of my initial exposure to entrepreneurship came from my father's granting me a $1,000 loan when I was in high school so I could launch a skateboard retail business. That experience and others left me with mixed feelings.

Here's some advice I gave my dad that I feel can be broadly applied to anyone considering borrowing from a family member or friend.

Related: How to Keep Family and Friends Loans Strictly Business

The dynamic should resemble that at a bank not one between relatives. I advised my dad to arrange the loan like it's coming from a bank not a great uncle. Repayment should be required. Payment terms can be flexible but the borrower should not be let out of the loan.

This is for the borrower's sake because the lesson learned otherwise is that it's OK to borrow money from people and not pay it back. That's not a good lesson for anyone of any age to learn.

Set up a payment schedule. If the new business isn't generating enough income, the borrower should have to earn the money in another way and send the payment every month no matter what. A penalty should be charged for late payment any month a payment is missed and every month thereafter until the borrower catches up.

Pay interest. The way the real world works is by charging interest on loans. If the borrower wants to pay less interest, repayment should take place faster. 

Going into debt to start a business is less than ideal in almost all circumstances. Borrowing from family and friends carries the risk of incurring personal fallout. But when this is the only way to start or fund a business, following the above steps can greatly reduce that risk.

Related: This Startup Will Give You a Loan -- But There's a Twist