If a traditional bank is leery of funding your start-up business, you may be tempted to turn to family and friends as a funding source, and it is a better option than credit card financing. However, it can be your worst nightmare, too. To help reassure initial investors that they won’t become fools who don’t get repaid, make your initial approach with a financial loan plan in hand. A plan isn’t the generic promise “I intend to pay this back.” It is a projection of how and when you will repay the loan, presented in writing.
This is especially important if any single loan is for $14,000 or more, as the I.R.S can then assess a gift tax. To avoid that, you’ll want a contract and an agreement to pay at least 0.05 percent interest as required. It’s wise to plan for a tiered three-year rate of return for larger amounts, to allow for building infrastructure the first year. Most businesses go in undercapitalized; that’s the number one reason for business failure. If you can, set up smaller initial payments with a larger balloon payment toward the end. The larger the investment, the longer you can make the terms. (Only parents are likely to wait three years to get back $500 without straining a personal relationship.) Meanwhile, save with an eye on that balloon.
Let’s say you’ve collected $10,000 from friends and family. Your promissory note to each one should include the date of the loan, the date by which it should be paid off in full, the minimum payment you’ll make, any interest, and the payment schedule. Try to stagger payments so that different people are paid different dates during the month to leverage your cash flow. Here are typical schedule options:
- Term payments based on agreements with individual investors. This is the most common option: “John, for your $1,000 investment, I’ll repay you $100 on the 15th of every month for 10 months, with an additional 11th payment of $50 for interest.” It presents a lower risk to investors but higher risk to the business, as you may initially have unprofitable months when you need to ante up personal monies to cover loan payments. If possible, tier payments or schedule every $1,000 or more over two years, with a higher interest rate as an incentive.
- Profit distribution based on equitable ratio reimbursements: Here you pay a minimum amount monthly, plus you pay a percentage of profits (say 30 percent) to lower the debt. For example, you might agree to a minimum of 4.5 percent of the total investment per month, plus a set percentage of profits. Example: You borrowed the $10,000 for a business that realistically should show a healthy profit in the first year. The first month, no profit and so you pay back the 4.5%, which is $450. Consider this to be a set business expense. Then, after all monies are in and debts are settled (including the loan payments), if you have a profit of $1,000 the next month, you would then distribute 30 percent of the $1,000 to your investors, or an additional $300. This actually helps you because for this type of loan, interest is based on how long it takes you to pay off the debt. The more you pay upfront, the more you save over time and the quicker your debt load is reduced.
Regardless of what terms you come to with your loved ones (and some are more creative than others), you’ll foster trust by (1) having open financial records with investors, and (2) by being frugal with regard to unnecessary expenditures at the cost of loan payments.
Figuring out the structure of a loan agreement and presenting reasonable payment options may go a long way toward convincing others of your ability to manage the business you are asking them to help you start.