Financing a Business Through Family and Friends

If you are borrowing from family or friends to start your business, consider the following tips:

1. Make the proposal professional. Put together a cohesive loan request just as you would for a banker. Present the proposal in a business-like manner, including financial statements, projections and tax returns.
2. Document the loan terms. Handshakes are never enough. Relationships can be ruined due to misunderstandings about loan terms. Put everything in writing, stating exactly how much you will be borrowing, how it will be used and how you plan to pay it back. Be specific about payment dates and interest rates. Your agreement should also specify if the loan will be secured (that is, will the lender hold title to part of your property?). You may want an attorney to prepare a promissory note or other legal document.
3. Use a fair interest rate. Lenders will be much more agreeable about delaying payments now and then if they feel the interest rate is fair. Contact a bank to determine the current commercial interest rate. The IRS has strong opinions about no-interest loans among family members: Loans made below market rates, or at no-interest, could be subject to federal gift tax.
4. Carefully plan payment schedules. Tie payments to your cash flow. Consider using an accountant to help you determine the best way to structure the loan. Avoid balloon payments or lump-sum payments at the end of the loan term—these are risky for both borrower and lender.
5. Cover your bases. Consider options such as a life insurance policy that would cover the debt in the event something happens to you before the loan is repaid in full. An attorney can advise you of other “bases” that should be covered depending on your individual circumstances.
6. Remember the tax benefits. While it may be tempting to avoid formalizing loans among friends and relatives, there can be tax benefits to using a formal promissory note. If the borrower cannot pay back the full loan amount, the lender is entitled to a tax deduction as “bad debt”—but only if the loan was formalized.

Barbara Cunningham, CunninghamB@missouri.edu
Business Development Specialist
Clay County, Missouri
University of Missouri Extension