Obtaining money from family or friends is probably the most typical form of financing for a small business, but there are hardly any guidelines (until now) in how best to make these arrangements.

You mean soon to be estranged family and ex-friends? 

Important Tip More detail, not less, is important to preserve relationships when raising money for a small business from friends and family

Some of the funding for some of the most successful start-ups in the world have come from so-called “friends and family” financing.  It often represents a quick and easy way to obtain funds for a small business – sometimes the only way.  Even though this is an important source of funds, there is little guidance about the best ways to obtain these funds.  Friends and family tend to be fairly casual in these types of relationships – while the flexibility is good, the lack of specifics can cause problems later.

One of the first things you and the other person need to decide if you want the person providing funding to be a shareholder (a member in the case of an LLC) or a lender.  The advantages of stock are generally no interest and no fixed repayment schedule.   The advantages of debt are a set return and no management rights.  Tax considerations are important also as interest is generally deductible by the small business but dividends on stock are generally not. 

We usually recommend borrowing money from family and friends through a simple promissory note, with easy-to-satisfy terms that will allow the business to pay off the debt comfortably based on its business plan.  We feel is the simplest way to obtain funds and the certainty of the note provides clarification to the relationship.  In addition, there are no management rights or appreciation issues to worry about later, like there would be with stock.  In many instances, if the small business is not able to pay off the note at its maturity, the “family or friend” member will be willing to renegotiate the note.

In any type of financing like this, you and your family/friend should consider the following things:

  1. How much money is being provided?
  2. Is it being provided all at once or over time?
  3. Are there any conditions that need to be met before the funds are provided?
  4. When will the funds need to be repaid?
  5. Do you want to provide for any flexibility on repayment times?
  6. What type of interest rate or dividend rate should the funds have?
  7. Should the repayments amount vary depending upon how successful the business is?
  8. Are there any management rights that should go to the person providing funds?

Based on the answers to these questions, you and your attorney can make a decision about the best kind of instrument for reflecting the funds.   In order to prevent harming the personal relationship with the “friend or family” member providing the financing and to avoid problems with any future source of financing, it is a good idea to have an attorney involved in preparing the documentation.  In addition, as with any financing for a small business, it is important that someone experienced determines that all securities laws are being followed.

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Important Tip: 
More detail, not less, is important to preserve relationships when raising money for a small business from friends and family
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