Raising Money from friends & Family: Loans or Equity?

According to research, 36% of funding for startups comes from family and friends. Furthermore, family and friends invest on average $23,000 in a startup.

Equity (Stock) or a Promissory Note?The idea of giving stock to family and friends is enticing. If the business does great, you will have the opportunity not only to make yourself rich, but also enable your supporters to share in your success.

ExampleEven a little bit of stock received very early on in a company’s life can make an investor rich. I remember a story about a painter that was decorating Facebook’s first office and received payment in stock. In the version of the story that I heard, the painter became a millionaire as a result of a few days of work.

What if the Company does poorly?Money invested in stock doesn’t have to paid back if the company goes bankrupt. A business owner does not necessarily have to spend years paying back investors, as they might with debt.

The Three Big Problems With The Equity Approach To Funding A Business

Problem 1

A successful outcome doesn’t necessarily lead to a situation where friends and family can turn their stock into big financial gains. Even if a company is doing well, for example producing a half a million in profits per year, your family and friends may not be able to turn their stock into cash.

Most Companies Aren’t Inherently Designed To Be The Next Facebook or Groupon

Problem 2

Even if friends and family own only a small sliver of a company, they may feel that they have the right to weigh in on company decisions. Family get togethers can potentially feel like a business meeting in which the owner must listen to hours of unwanted advice.

Friends and Family that own Stock are Minority Owners

Problem 3

How much is your company worth? Early stage companies are very difficult to value. The founders of companies often have unrealistic expectations, which tend to get re-adjusted during the process of raising money from professional investors and financial institutions.

There is the Question

of Valuation

The Alternative To Equity: A LoanWhile a loan is not as sexy as equity, it does not have the problems mentioned above. If the company is successful, friends and family will get back what they invest and earn interest. Even if the business doesn’t work out in the long run, a business owner may be able to pay back some or all the money.

The Right Way to Borrow MoneyWhen borrowing money, there are a few key question that you need to decide:1. Personal or Business Loan 2. What Interest Rate and for how

long? 3. How should the Loan be

documented and the Loan Payment s be handled?

Personal or Business Loan?It can be much simpler and less expensive to take money as a personal loan, rather than borrowing money as a company. However, taking the loan as company provides some separation between personal finances and the business.

2.

An interest free loan can be a very bad idea, even if the lenders don’t care about receiving a positive return on their money. The problem is the IRS might take the opinion that the loan is in fact a gift from the borrower, rather than an investment.

What Interest Rate?2.

Which are the minimum rates they expect on loans based on the term of the loan. Applicable Federal Rates are updated monthly on the IRS website.

The IRS publishes an index of Applicable Federal Rates,

A Market Based ApproachThere are firms, such as Prosper, that provide personal loans for business purposes. The average interest rate changed by these firms is around 15% per year. As the purpose of a friends and family loan is to help a person start a business, the loan rate should well be below these market rates.

What should be the

Length of a Loan?It often takes businesses three to five years to start turning a profit. The longer the loan, the smaller the loan payments, and the easier it will be for the business to succeed during those first few critical years. If putting the business in a good financial position to survive is the primary concern, a loan of 10 years or longer makes sense.

What should be the

Length of a Loan?However, most startups don’t last 10 years. Many businesses last only 3, 4 or 5 years. A loan of 3 to 5 years represents a compromise between how long new startups tends to last and putting the business in the best position succeed.

How should the loan be documented and payments handled?

3.

The IssuesA promissory note will provide clarity to both sides on the following issues:

1. How much is being borrowed? 2. At what interest rate? 3. When will payments be made? 4. What are the consequences for non-payment?

Why a Promissory note?Without it, there is a much greater opportunity for misunderstandings and disagreements later on. While there are a plethora of free promissory notes available online, we highly recommend that using a paid service, such as ZimpleMoney or TrustLeaf for personal loans and InvestNextdoor for business loans.

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