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Borrowing Money From Friends and Family

 

According to Forbes, loans from friends and family are the second most popular source of funding for small businesses.[1] For good reason! As an entrepreneur, borrowing money from friends and family has some serious perks. For instance, a friends and family lender may not conduct credit checks or require a borrower to pledge collateral. They may also offer more flexible repayment terms than traditional banks, which can be particularly useful for entrepreneurs in the start-up phase. And, in some cases, a friends and family lender may charge a lower interest rate on the loan.[2] Plus, unlike giving ownership interests, (known as equity shares), in exchange for cash, loans do not require business owners to dilute their own ownership interest in the company. All-in-all, friends and family loans can be a useful option for small businesses looking for funding.

Even with all of the obvious advantages, borrowing from friends and family is not without risk. The primary risk being the possibility that the borrower will not be able to repay their debt and the lender will be left without recourse, causing the parties’ personal relationship to suffer. So, how can business owners reap the benefits of friends and family lending, while minimizing risks for both parties? The solution, by executing a formal, legally binding loan agreement that sets forth the terms of the loan and repayment plan. 

Reasons to Use a Written Loan Agreement

Business owners may be tempted to reach handshake deals with friends and family lenders. And sure, entering a binding legal contract with your grandma or college roommate may feel a bit more awkward. Nonetheless, a well-written loan agreement serves several important purposes. First, it confirms that the parties’ have a mutual understanding of the arrangement, which may help prevent disputes from arising. Second, a written loan agreement may be required to prove compliance with federal tax laws (discussed below). And third, it provides both parties with protection if a dispute arises or an event of default occurs. 

Important Loan Agreement Terms

A private loan agreement between friends and family is customizable and can contain any number of terms. Below are a few important loan agreement terms that should be considered. 

  1. Repayment Terms. Friends and family lenders are likely to offer flexible repayment terms. However, the loan agreement should still define important repayment terms like the term of the loan (i.e., the length from the start of the loan to the date it must be repaid in full), payment amounts, and frequency of payments. It may also include more specific terms like whether prepayments are permitted. 

As a general point of clarity, the parties should specify the loan’s interest rate in the loan agreement.[3] Putting the interest rate and loan terms in writing is important for federal tax purposes. The IRS considers loans over $10,000 to be “gifts” unless their interest rate is proven to be at or above the prevailing applicable federal rates (AFRs). If the loan is considered a gift, the lender may face tax liability for “imputed interest.”[4] This means the IRS will use the AFR to calculate how much interest the borrower should have paid to the lender and include this amount in the lender’s taxable income.[5] Note that loans under $10,000 are not subject to the imputed interest rules. 

  1. Collateral. If the loan is secured by collateral[6], the loan agreement should include a clause specifying which business assets are pledged. Prior to agreeing to a collateral term, borrowers with multiple outstanding debts must ensure that pledging a particular asset as collateral for a new loan does not violate any terms or covenants in an outstanding loan agreement. This is particularly important for friends and family loans because the lender typically will not conduct a credit check or lien search on the borrower’s assets. 
  1. Restrictive Covenants. When there is an unsecured loan (i.e., a loan that does not require collateral), the lender may require the borrower to adhere to restrictive covenants. A restrictive covenant in a loan agreement bars the borrower from taking a certain action. For instance, the borrower may be prohibited from entering into a loan agreement with another lender. While this can increase the lender’s confidence that he or she will be repaid, it may also prevent the borrower from obtaining much needed financing in the future. 
  1. Personal Guaranty. If the business is organized as a limited liability company or corporation, the owner’s personal assets are generally shielded from the liabilities of the business. However, in some cases, a lender may want the business owner to sign a personal guaranty, which is a promise assuming personal liability to satisfy the debt if the business defaults on payments. 
  1. Missed Payments. With any borrowing arrangement, it’s a good idea for parties to preemptively agree on a course of action for dealing with missed payments. This is particularly important for loans from friends and family, as having a plan in place can reduce tensions and preserve the parties’ personal relationship. The loan agreement may provide that the loan agreement and repayment schedule may be amended in certain circumstances. Or it may impose penalties for late or missed payments, such as a reasonable late payment fee or taking of collateral. 

Be aware that if the lender forgives some or all of the borrower’s outstanding debt, the IRS may consider this cancellation of debt as income to the borrower and this imputed income could be includible in the borrower’s gross income[7]. Business owners considering loan forgiveness should consult with a tax professional. 

Other Types of Family and Friends Financing

In addition to loans, friends and family can be key actors in supporting small businesses through other avenues of financing. Namely, purchasing equity (i.e., an ownership interest) in the company. Unlike loans, money exchanged for equity does not have to be repaid at a later date. [8]Friends and family equity financing may be a good option for certain companies depending on their business goals.[9] Because of the unique legal and tax considerations, business owners considering any type of friends and family funding should seek legal advice prior to entering into a financing agreement.

By Ivy Devadas

 

 


[6] Collateral is property owned by the borrower which is pledged as security for the repayment of the loan. If the borrower defaults on payments, then the lender can seize the collateral to satisfy the borrower’s outstanding debt.

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