Start-up Loans from Friends and Family

Mar 23, 2017

It is often said that the first place start-up business ventures seek capital is from friends, family, and fools. Borrowing from friends and family can be an effective transactions among the parties. One of the benefits is that the borrower does not have to deal with a myriad of loan applications, dredging through the lending process, and receiving multiple rejections. However, selecting the proper loan type could be critical to the success of a project. Consulting a business attorney to assist with drafting credit documents among friends or relatives can be an excellent alternative to dealing with banks.

Entrepreneurs may be tempted to take shortcuts to save time or legal fees when borrowing money. However, start-up businesses should take the credit process seriously by evaluating the need for credit and assess the business’s overall financial situation before borrowing money.  When planning for business credit, it could be helpful to consider the following:

(1) What is the purpose of the credit?

(2) How much money is needed?

(3) What is credit profile of the borrowers?

(4) When is the money needed?

(5) What is the expected time for repayment?

To help the lender feel more comfortable extending credit, the start-up should consider whether there are any assets that could be used as collateral to secure the credit. There are three major credit types of credit that banks typically offer, but could be effectively extended from friends or family as well: term loans, draw loans, and revolving lines. 

The term loan is a single advance of full amount on the loan closing date. Repayments are based on an agreed-upon schedule and interest rates, and the selected interest rate usually remains the same for the life of the loan. Term loans are often used by small businesses to purchase long term assets such as equipment.

The draw loan, which is commonly used in construction lending, is a multiple advance loan where the advances are made over time under an agreed-upon schedule. In other words, money is taken from a certain loan amount through a process called a “draw.” Draws vary depending on the agreed-upon terms. The draws usually occur upon the completion of a predetermined stage of a certain project or periodically. A draw loan that is repaid may not be re-borrowed. Once all of the funds are drawn from the credit facility, the total amount of debt is usually then converted to a term note, or paid-off through other means.

The revolving line allows the borrower to repay and re-borrow funds up to a certain amount over and over again (like a credit card). In other words, a revolving line may be re-borrowed indefinitely as long as the borrower pays the specified amount at its due date. In the business arena, this type of credit is commonly referred to as a “business line of credit,” which is similar to personal lines of credit. Lines are often used for short term assets such as acquiring inventory or covering expenses while waiting to collect accounts receivable. 

When asking money from friends and family, producing a formal business plan, financial statements or projections (such as profit and loss, balance sheet, and cash flow statements), and the individual’s personal credit scores can be a professional way to approach the subject. Additionally, having the proper loan documents drafted by a business attorney can also help memorialize the transaction, mitigate the potential risks and liabilities, and protect close family and friend relationships by setting concrete expectations for the transaction.

By Brian Kirkpatrick