Even when credit is flowing, it's still tough for small business owners to get a loan. As a result, they often will look for financing from friends and family (known as a private loans). Some of the world's greatest businesses got their start from this approach. For example, Walmart's (WMT) Sam Walton got a $20,000 loan from his father-in-law.
Of course, there are many risks when putting together a loan from friends and family. After all, if the principal and interest cannot be paid back, there could be family discord or a lost friend.
So, here are some tips to help make the process successful:
Business Plan: This is the first step. Now, it does not have to be extensive; it could be just a few pages. But make sure you have realistic forecasts for the next two to three years, as well the amount of capital you will need to achieve your goals. As much as you can, try to research your business and get a sense of the risks.
Another good idea is to put together an investor presentation. Again, this should not be long but instead focus on the key highlights of the investment opportunity, such as the market, the product or service, the forecasts, and so on.
Pitching: When borrowing money from friends and family, the process can take awhile -- say six months or longer. No doubt, they are taking a big risk and want to make sure they are making a good investment. So, you will need to be proactive when courting investors. Don't expect an immediate "yes" to your pitch.
Documentation: Make sure you have a promissory note, which specifies the interest rate and repayment schedule. Also include what happens if there is a failure to pay (perhaps the lender has a right to collateral). You can get a promissory note from LegalZoom, Nolo Press or Intuit. I also have some tips on this topic from my blog.
Flexibility: Unlike a typical bank loan, you can provide more flexibility with the terms. Perhaps the most important is the time for the payback. Given that the first year is often the toughest, you can structure a loan that has no interest for the first six months or so. Then after this, interest can be payable on a monthly basis. Or, if your business is seasonal, you might want to have a loan that provides low interest payments during off-periods.
This kind of flexibility can help you grow the company, which is certainly a win-win.
Finally, be wary of balloon payments. These can be extremely tough to pay off and even harm your business. Rather, it is a good idea to have a loan that provides for ongoing interest and principal payments.
Taxes: There are several strategies to consider. For example, a person can gift up to $13,000 per year to anyone without paying gift taxes. Thus, if a family member or friend is making a loan, there may be a tax advantage to limit payments to this annual amount, just in case there is a default.
Next, if the loan has a below-market interest rate, the IRS may consider this to be a gift. To avoid this, you can use the IRS applicable federal rate (AFR) for your loan.
Finally, make sure you deduct the interest payments for your business. Of course, this can be a nice tax benefit.