Sometimes it seems like borrowing money from your friends or family is the only option to fund your business. If it is, weigh the benefits and drawbacks before stepping into the situation that can affect your relationship.

Often, the biggest supporters of your small business are your friends and family. Naturally, you might consider asking them for a loan before going to a bank. But is it a good idea?

Pros: Where Else Will You Find Such a Lenient Lender?

If your relationship with the person offering you a loan is solid and you think it can withstand the pressures of a business relationship, consider taking the loan. Especially in difficult economic times, a friend may be the fastest and most reliable source of financing for your business.

Set up expectations up front (how strict will she be on payments each month, what interest will you pay and what happens if you can’t make a payment) and draw up a simple loan contract. Also, provide your new lender with a copy of your business plan so she understands where you’re headed with your company and how you plan to get there.

Treat this loan as you would a loan from the bank and pay it on time. Don’t take advantage of your friend’s generosity, or it might ruin your friendship.

Instead of taking out a loan, consider taking on your friend or family member as an investor. Can she help you run your business? Does her background provide benefit to your company? Even if her experience doesn’t fit into your operations, she can still become an investor and receive a percentage of your company’s profits or the sale of your company when it comes time to exit.

The benefits of a loan from a friend can save you a great deal of money:

  • Your friend may extend the term of the loan, helping you reduce monthly payments, which frees up your cash flow.
  • Your friend may offer a lower interest rate than what a bank would.
  • You may not need secured collateral for the loan, whereas you would with a bank.

Cons: You Value Your Friendship

While your family supports you in your business endeavor, they might not truly understand the risks they would be taking if you were unable to pay off the loan they give you. If your business fails and you are unable to pay the loan, you may put your family member in his own financial crisis. This can put a serious strain on your relationship. Is it worth the risk?

Determine how business savvy your potential lender is. If it is your mother, she may just love you so much and want to help you out, but what happens if you can’t pay her? She may not understand business loss the way someone who owns his own business would. On the other hand, if you have someone with business acumen willing to lend to you, make sure the deal is good for both parties, and that he is not taking advantage of you because you can’t get a loan elsewhere.

There’s no turning back from a relationship ruined by business, so think carefully on whether this is the best financial resource for you. If you are unable to pay the loan, your lender may have to take a bad debt deduction on his taxes.

Working Out the Details

If you decide to take out a family loan, take these measures. First, review with your lender what happens if you are unable to pay the loan. He needs to understand how this affects his financial and tax situation.

Then, determine how much you can afford to pay each month on a loan. Ask for the maximum time to pay off a loan (five years is typical through traditional lending), and then determine how much the total loan should be. Don’t forget to include interest (if your friend is charging it) in your payment calculations.

Next, fill out your loan contract with the agreed-upon amount as well as what the monthly payments will be, and when the final amount is due. Have both parties sign this and make a copy for each.

Make sure you have a solid business budget, and build in your monthly loan repayment with interest. Look to reduce costs wherever you can so that you ensure you can pay the loan back each month, even when sales are low. Make paying it your first priority.

Communicate with your lender regularly about how your business is doing, especially if he can provide insight for improvement. Open communication can prevent any misunderstandings down the road.