Tips to Know Before Borrowing from Family to Start a Business

In today’s stricter financial markets, one of the fastest ways to start a business is to turn to family and friends instead of the neighborhood bank.

But before you look to your parents and extended family to be private investors, you should think long and hard about whom to approach and if you are ready to be a business owner. Lately, I have been noticing more legal conflicts because entrepreneurs didn’t clearly spell out the role of the investor when opting to borrowing money or sell an equity stake. Understanding and managing investor expectations is something that profitable companies are successful at.

Here are the top three tips to consider when approaching family members about becoming investors:

1. Loan or Share? It’s important you understand the ramifications of the different scenarios. When you ask for a loan, it requires you to pay the money back in a timely manner, possibly with interest. Failing to pay back the loan not only can cause you some legal trouble but can damage your relationship. This is especially true when the loan is made on an oral promise – a sure way to create problems in the future – or isn’t documented properly. I’ve seen family ‘loans’ written in a paragraph for rates exceeding 100% interest, which is not legal in Texas, and which are meant to be secured in some way but often aren’t.

When it comes to giving family or friends a share of the business in return for their money, it’s critical that you spell out their roles in the business. Are you going to give them daily operational decision-making authority or just seek their advice in specific situations? Or is their goal to simply be so-called ‘silent’ investors? Have you mutually discussed what would happen if the business needs more money or, like many startups, fails?

2. Due Diligence. Your great business idea must be fleshed out beyond the idea stage before you start collecting money. You should have a viable business plan and experienced attorney to help you set up the business. One of the top ways to be dragged into a lawsuit by your family or friend investors is not having the proper legal, organization and financial records in place. For instance, if you never show investors any financial statements and they have a significant role in the business, it could be considered a red flag worth closer scrutiny especially if the business promotes itself as being successful. You could wind up on the wrong side of the state securities board or attorney general’s office for unlawfully soliciting investments or in a lawsuit for fraud. If you properly document and explain the risks and benefits associated with your business, you can minimize hurt feelings and the risk of legal action later.

3. Keep it Strictly Business. Once you bring family or friends into the business, it’s extremely important you separate their role in your business from your personal relationships. You may want to stipulate in advance that only business issues will be addressed in the workplace and during business functions and institute policies to enforce this practice. If you have employees, it is especially critical to discuss what roles and level of communication family and friends will have with staff. If you get caught in family squabbles with your new investors, they may want to retaliate by requesting their loan repayment sooner, especially if it was the sort of loan done on a ‘handshake.’

Last but not least, avoid falling into the ‘it won’t happen to me’ trap that most small businesses working with family and friends succumb to; you are going to have challenges and disputes if you borrow money from or get investment dollars from friends or family. The key is to understand and manage expectations, document properly, and prepare accordingly.

If you need legal advice, schedule a meeting with Tiwari + Bell PLLC through our website or by calling (210) 417-4167