If you’re a small business owner in the market for a business loan, you have most likely already talked to your local bank or other small business lender. And no matter how affordable the loan options, one option is consistently appealing: Borrowing from a friend or family member.
You might have wealthy family members or friends who are happy to cut you a check with no conditions or stipulations, but there are more factors to take into consideration when borrowing from someone you know, other than just how much they can lend you. Here’s a rundown of what you should consider and how to best navigate the situation.
You’re More Likely To Be Approved
Let’s state the obvious: A family member likely won’t put you through the same vetting and underwriting process that a bank or lender will insist upon. Though diligent investor-types may ask to review your business plan and check your business credit history, they will hardly hold you to the same stringent standards that most lenders have.
Typically, to get approved by a bank, you need strong business and personal credit scores. You’ll also need to have been in business for a few years—the longer the better. And the underwriting process can take weeks or months as the lender reviews your existing debts, cash flow, and other factors.
One of the appeals of a family loan is that they’ll be more likely to “approve” you, and quickly, due to your personal connection. If you have less-than-stellar credit or are the owner of a new business, a loan from family may be your best way (though not the only way) to get capital fast.
You’ll Probably Receive Generous Terms
On a related note, it’s likely that one of the reasons you’re considering a loan from a family member is that they’re willing to give you terms no bank would. Even the most popular SBA loan—the SBA 7(a), considered one of the best loans a small business can qualify for—has an interest rate starting at 7.75%.
The amount of money you need, the interest rate you can afford, the time period you need to pay the loan back—all of this can be hashed out with your family in a way that makes the most sense for you.
Loans from traditional lenders may also offer you affordable terms, but they will always be advantageous to the lender, which is trying to maximize their take from the transaction.
Debt Or Equity: Which Do You Prefer?
Taking out a loan is known as debt financing: You go into debt in order to fund your business, then pay that debt back on a predetermined schedule.
Another form of financing is equity financing: You take on funding as an investment, just as you might from an angel investor or venture capitalist. From then on, your family member will be a financial partner in your business and may expect to have a say in business decisions.
It will be up to you to decide which kind of funding you prefer. If your family member is an experienced business owner, you might appreciate bringing them into the decision-making process and having their advice and input. On the other hand, you may prefer to keep your autonomy, limiting your family’s involvement to this particular infusion of capital.
You’ll Still Need To Formalize The Loan
Here’s where things get tricky. You might be tempted to keep things informal with your loan from a family member. Why get bogged down in paperwork and logistics when they can just hand over the money, and you can hand it back—as promised—bit by bit?
There are both legal and logistical reasons that you’ll want to create formal documents for a business loan, even one between siblings or from parent to child:
- Ensures financial responsibility: By borrowing money for your business from family, you’re taking advantage of an opportunity that isn’t available to many business owners. Learn and engage in financial responsibility by making a business plan for the exact amount of money you need, and a payment schedule that you stick to no matter what. Then, when the time comes for a loan from an outside lender, you’ll be ready.
- Takes nobody, or their money, for granted: Lacking formal documents gives you wiggle room to submit late payments or neglect your responsibilities, creating discontent. You would not be the first person to have a falling out with a family member over money. By creating formal terms that you uphold, you’ll signal to your family that you see them as legitimate creditors and/or investors that you respect.
- Helps avoid tax issues: We’ll go into more detail below, but if your loan from a family member is for a substantial sum of money, understand that the IRS will get involved, whether you like it or not.
Your loan agreement should outline, at a minimum: The amount of money changing hands; a repayment schedule; interest payments; whether the loan is secured with collateral or unsecured; and the role the investor will play, if any, in business decisions.
You can convene with an accountant, legal professional, or third-party service to help draw up the formal structure of your loan and ensure that both sides do their part to uphold it.
Even A Family Loan Has Tax Implications
As mentioned above, there are tax implications to most business loans you take on, even if they’re via family.
A verbal or otherwise informal agreement may seem easier than writing up a formal loan document, but not where the IRS is concerned. If your family member loans you over $13,000 and the IRS views it as a gift because there was no intention to repay it, they will become subject to federal gift tax rules and will be required to pay taxes on that money.
If your family member wants to charge you interest, it can’t be for a wildly under-market interest rate (anything below 1.78%, according to TurboTax). An interest rate of fair market value helps prove that this is a legitimate business loan.
If your family member is fine with extending you a no-interest loan, it needs to be for less than $100,000. Anything more, the IRS will charge the lender imputed interest, taxing them as if they were receiving interest on your loan.
In addition, a formal loan document will help your lender write off the loss if the business doesn’t end up working out.
You’ll Have To Balance The Personal With The Professional
This final point has been the throughline of much of this article, but it bears repeating: Taking on a loan from a family member means mixing your business and personal lives.
For some people, that’s okay: They feel confident they can balance the needs and egos of their family members in exchange for working capital. Others may not enjoy this process and might consider keeping everything professional by sticking with a third-party lender.
If you do take out a loan from a family member, best practices include keeping your lender appraised of how the business is doing—so there are no surprises—and, of course, keeping up your end of your formal agreement.
A loan from a family member can be a unique opportunity to grow or scale your business with affordable, flexible financing. It can also be the first step in a long line of financial decisions that hamper not just your small business, but your familial relationships.
As with any loan, do your research and speak to your advisors before taking on such a large financial and personal responsibility. Just because it’s family doesn’t mean it will be easy—in fact, in some ways it might be even harder on you than repaying a traditional loan.