It’s not hard to see the advantages of borrowing from friends and family – because they believe in you and know you well, they are more likely to have fewer requirements for handing over cash than financial institutions, not to mention they are more likely to give a lower interest rate for a loan.
The downsides, of course, is that you are potentially placing your personal relationships at risk if things go wrong.
Below is a guideline for the right way to get friends and family to fund your business without risking your relationships.
Don’t confuse business and personal
Just because you are borrowing money from family or friends, doesn’t mean that you can skip the business details. In order to preserve your relationships, it is critical that a formal loan contract is drawn up that contains all the details of the terms of the loan. This module outlines some of the preparation you’ll need to do in order to meet the expectations of the people who loan you money.
Know the difference between in-kind vs cash vs surety
Often family and friends may not have the money you need but can offer equipment. For example, they may have a car, or computer and printer, that you need to run your business. This loan also needs to be recorded in a business contract that clearly spells out responsibilities, costs and repayments.
The other way that friends and family can help is by standing surety for your loan application. What this means is that you will not have to find the collateral money for the loan. However, you do need to be clear on that fact that if you cannot repay the loan, your friend/ family member who stood surety will be responsible for repaying the full amount plus any interest due! So once, again, this needs to be recorded in a business contract that clearly states how you will repay your friend/ family member in the event that the business cannot repay the loan.
It can be difficult to ask for large amounts from friends and family, so the question to ask is whether you can find enough people within this group to each loan you a smaller amount
Prepare a pitch to friends and family
Before you approach family and friends, you need to do the research and make sure you are able to answer all their questions and can clearly show how the additional items or money will grow your business.
The first step is to prepare a business case. The aim is to set out how much you need and why. You also need to show the impact that the additional items or cash will have on the growth of the business and clearly show your ability to repay the loan. This document needs to include financial statements that show the past financial performance of the company and the future projected financials. Make sure you also develop a cash-flow document as this will back up your claim that the company will be able to repay the loan.
The business case is an extremely important document as some friends or family may prefer to buy into your business, and this document will help them understand the business and get a good idea of its value. In other words, if your family or friends wish to become equity partners in your business, you will both be working from the business case to discuss the equity options.
It is important that this document contains a section that discusses the possible risks facing your business and what steps you have put in place to mitigate them. The chances are that the people who can lend you money have a good idea about how businesses operate and they will be looking to see that you have covered all angles.
Explain all the options
Before you approach family or friends, you need to be clear about what you need. For example, do you need cash, equipment or both and what is the total value of this need, and what are you prepared to offer in return for their assistance? That is, will equity shareholding be an option? What is the maximum amount you can afford to pay back per month? What will you do if the business does not grow as expected?
Make a list of people you can approach
It can be difficult to ask for large amounts from friends and family, so the question to ask is whether you can find enough people within this group to each loan you a smaller amount. You still get the total amount you need, but instead of owing to only one person, you will owe money to a number of people.
This option takes a little longer to get off the ground due to the number of people you need to work with. However, it can be a valuable way of raising money.
Test the reaction
You are now ready to chat informally with a few friends and family members that you believe are possible candidates to help you. The aim is to gauge their reaction.
Prepare a loan contract
Hopefully, you received a positive response to your appeal for assistance. If so, you now need to prepare a draft loan contract that sets out the details of the loan and will form the basis of a more formal discussion to finalise the loan.
If you have never created documents such as these, it is advisable to get assistance from a qualified business advisor. This is an important document and needs to be fair to both parties and able to withstand questions in a court of law.
If equity is an option that the lender is keen to exercise, then shareholding details need to be included in this document. You will need to include the following details: equity split, the value of shares, the role of the investor in the business, return on investment and details of an exit plan.
In the case of a loan, details that need to be included are the duration of the term, the interest rate and the backup plan for repayment in case your business struggles.
If the investor is standing surety for a bank loan, then this document will state the terms of the surety and the backup plan for repayment in case your business is unable to honour its obligation to the bank. It is often expected that the surety is limited to the loan amount only and does not cover the bank’s interest charges.
This article first appeared on Finfind.co.za, it is republished here with permission.