The most common source of debt financing for start-ups often isn’ta commercial lending institution, but family and friends. It makessense. People with whom you have close relationships know you arereliable and competent, so there should be no problem in asking fora loan, right? Keep in mind, however, that asking for financialhelp isn’t the same as borrowing the car. While borrowing moneyfrom family and friends may seem an easy alternative to dealingwith bankers, it can actually be a much more delicate situation andit’s important to be as disciplined as you would be in dealing witha professional investor. Here are some basic rules:
Treat them as if they were strangers. Forget for themoment that your investor is a friend or family member. Make it an”arm’s length” transaction, and insist on the same sort of legaldocumentation you would prepare if your investor was a totalstranger. Why? Because too many entrepreneurs borrow money fromfamily and friends on an informal basis. The terms of the loan havebeen verbalized but not written down in a contract.
Lending money can be tricky for people who can’t view thetransaction at arm’s length; if they don’t feel you’re running yourbusiness correctly, they might step in and interfere with youroperations. In some cases, you can’t prevent this, even with awritten contract, because many state laws guarantee voting rightsto an individual who has invested money in a business. This can,and has, created a lot of hard feelings. Make sure to check withyour attorney before accepting any loans from friends or family. Soif it’s a loan, have your lawyer prepare an I.O.U. (called a”promissory note”) for the friend or family member, and don’t offerless than a “commercial” interest rate.
Debt may actually be better than equity. If someone”lends” you money, you only have to pay it back, with interest.They can’t tell you how to run your company. If someone buys stockin your business, they are legally your business partner. When indoubt, make it a loan, and pay it back as soon as you can.
Tie all payments to your cash flow. Try to avoidobligations with fixed repayment schedules. Consider instead “cashflow” obligations, in which your investor will receive a percentageof your operating cash flow (if any) until they either have beenrepaid in full with interest, or have achieved a specifiedpercentage return on their investment.
Consider nonvoting stock. If your friend or family memberinsists on buying stock in your company, try to make it nonvotingstock, so they don’t have the right to second-guess your everymanagement decision.
