Raising money from friends & family: loans or equity

Raising money from friends & family: loans or equity -

The first financial supporters of the new companies are often family and friends of the founders. Studies have shown that 36% of funding for start-ups comes from family and friends. In addition, family and friends to invest an average of $ 23,000 a startup. This article will explore the complexity of the adoption of this money in the form of equity or a loan, such as the friction to minimize, if the investment is made, and to pay a possible tax issue interest related.

Did you know? If you have more than $ 50,000 in your retirement account, you can use this money to start or buy a business without having to pay early withdrawal penalties. Click here to read more

Contents:.?

• equity or promissory note (debt)
• 3 Big Problems with the equity
• loans as an alternative to stocks
• Personal or Business -Loan?
• The adjustment of the interest rate to borrow
• as determine length of the loan
• Should How documenting the loan

If you equity (shares) or a promissory note to family and friends to give, willing to invest?

The idea inventory of family and friends of giving is tempting. If the business is doing great, you will have the opportunity not only to get rich, but also your followers make in your success to divide.

Even a little bit of stock received very early in the life of a society can make you rich an investor. I remember a story about a painter who Facebook first office and received payment in stock was the decoration. In the version of the story I heard, the painter became a millionaire as a result of a few days work. Would not it be great if you could make your friends and family rich?

On the other hand, there are advantages to give stock if the company does poorly. have invested money in stocks, not to be repaid if the company goes bankrupt. An entrepreneur does not have to spend years to repay investors as they could with debt.

The three major problems with the equity approach to financing A Business

Problem 1:

most companies are not designed by nature to be the next Facebook or Groupon

If you open a restaurant, a hair salon, or hundreds of other companies, a successful outcome is not necessarily in a situation lead, where friends and family who turn their stock in large financial gains. Even if a company is doing well, for example, half a million in profits annually produce, your family and friends may not be able to make their shares into cash.

difficult to find potential buyers for stock companies, in which the minority shareholders are little or no control. When a business owner sells their friends and family stock, in many cases they will stick them with an illiquid investment

Problem 2 :.

friends and family that own stock are minority shareholders.

Although friends and family have only a small sliver of a company, they may feel that they have the right decisions to weigh on companies. can family reunion may feel like a business meeting, in which the owner must hear hours undesirable Council

Problem 3 :.

There is the question of the review.

How much is your business? Early stage companies are very difficult to evaluate. The founders of companies often have unrealistic expectations, which tend to be set again during the process of raising money from professional investors and financial institutions

The alternative to equity :. A loan

While a loan as equity is not so sexy, it is not have the above mentioned problems. If the company is successful, friends and family will get back what they invest and earn interest. Even if the company does not work in the long run, a business owner may be able to use some or all of the money to pay back, especially if the owner Monthly payments.

When friends and family loan money, they are not a minority shareholder. While they want to be able to give "free and helpful" advice, they can not be taken as a business decision, to the feeling. Moreover, a business owner does not have to share as much detailed information of what happens to foreign investors in the company.

The proper way to borrow money

When borrowing money there are a few important question you have to decide.

1. personal or business loan
2. Which interest rate and for how long?
3. How should document the loan and the loan payments are handled?

personal or business loan?

While entrepreneurs see many not much difference between them and their companies to borrow money at an early stage, there is a big difference from a legal perspective. It can be much easier and less expensive to take his money as personal loans, rather than to borrow money as a company. However, the loan provides as a company takes a certain separation between personal finances and the business, the owner may allow, is not required to repay the debt to be paid back if the company goes bankrupt. These differences and others are described in detail in our article on the IOUs discussed

What rate

AFR minimum prices .? - An interest-free loan can be a very bad idea, even if the lender does not care about a positive return on their money to obtain. The problem is the IRS could take the view that the loan is in fact a gift (and subject to the gift tax) of the borrower, rather than an investment.

A test that is applied is the interest rate on the money. The IRS publishes an index of Applicable Federal Rates, which are the minimum rates they expect for loans based on the life of the loan. Applicable Federal Rates are updated on the IRS website monthly. In October 2014, the minimum interest rate was 0.38% for loans of less than 3 years and 1.85% for loans from 3 to 9 years old. These prices are much lower than "market prices".

A market-based approach

There are companies that provide such Lending Club, the personal loans for business purposes. The average interest rate has changed by these companies is around 15% per year. Since the purpose of friends and family loan is to help a person to start a business, the credit rate should be under these prices in the market well. An interest rate in the neighborhood of 6-10%, represents the central area between the AFR minimum rates and current market rates.

What should be the length of the loan?

it takes for a company for a certain time to establish itself. It often takes companies three to five years to start a winning turn. The longer the loan, the smaller the loan payments, and the easier it is will be for the company to succeed during these first critical years. When in a good financial position, put the business in order to survive is the primary concern, a loan of 10 years or more meaningful.

However, most start-ups do not last more than 10 years. Many companies hold only 3, 4 or 5 years. Most business owners want their borrowers to pay back, while the business is a constant concern. A loan of 3 to 5 years is a compromise between how long new startups tends to keep the business in the best position and set to succeed.

While, the borrowing paid back in one lump sum or installments, we will highly recommend the means to pay back in equal monthly installments during the term of the loan.

How to document the loan and treated payments?

There absolutely should be a legal document, a promissory note signed, if the money borrowed. A promissory note will provide clarity for both sides on the following topics are available:

1. is how much borrowed
2. to what the interest
3. When are the payments? made?
4. What are the consequences for non-payment are?

Without the promissory note stuff to put in black and white, there is a much greater chance for misunderstandings and disagreements later. While there is an abundance of free notes are available online, we strongly recommend that a paid service, as ZimpleMoney or TrustLeaf for personal loans and Invest Next Door for business loans.

can provide these companies also support the logistics available providing monthly payments to the borrower. For example ZimpleMoney provides a service, allowing you to make a lump-sum payment and treat the distribution to the borrowers. TrustLeaf takes a basic approach. It sends both the borrower and lender e-mail reminders that payment comes up, and for the amount that should be paid. However TrustLeaf has more functionality to the opportunity to share friends and family to invest in debt.

Did you know? If you more than $ 50,000 in your retirement account, you can use this money to start or buy a business without having to pay early withdrawal penalties. Click here to learn more.

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