To successfully borrow money from people you know, it is important that you overcome

1. Financial Risk: You must demonstrate to people who might be potential lenders that your business has a reasonable chance of success, and that their investment in it is a smart one. Lenders will want to see that you have the necessary skills, have thought about the risks involved and have a plan in place to minimize these risks while growing your business.

2. Emotional Risk: You must convince people who might be potential lenders that investing in your business will not jeopardize their relationship with you. When it comes to borrowing money from people you know, we realize that small business owners will be at different points in the process–some of you may be uncertain as to where or how to begin, while others may already have specific lenders in mind.

Businesses in existence for less than two

Years typically find it difficult to get loans

From commercial lenders because the

Businesses are viewed as a high credit risk.

Debt vs. Equity Financing

Although this guide focuses on how to borrow money from people you know, it is still important to understand the types of financing that are available to small business owners. This way, you can determine which type, or combination of types, makes sense for your situation. After all, it is not uncommon for small business owners to receive financing from several sources, one of which is usually friends, family, and other private parties.

Debt Financing is money that you will pay back, usually with interest, over a set time period and in accordance with pecific terms. Some traditional sources for debt financing are banks and credit cards. There are also numerous programs offered by federal, state, and local governments that hope to encourage the growth of small businesses because of the positive effects they have on the economy. Another source for debt financing is borrowing from people you know, such as family, friends, and business associates. Many of today's successful companies, including Motown Records and Crate & Barrel,

started out this way.

 

Equity Financing involves giving up a portion of the ownership of your business in exchange for money received from equity investors. Because equity investors are buying a piece of your business and essentially becoming joint owners, if the business fails you generally are not obligated to pay the money back. On the other hand, if the business succeeds, equity investors share in the financial success well beyond recouping the money they originally invested into the business.

Common sources of equity funding:

• Venture Capitalists: professional investors who are looking for a higher rate of return by investing in

high-growth business ventures

• Angel Investors: high net worth individuals who invest in businesses on a private basis

Debt Financing

Pros:

- Typically easier to get than equity financing

- Wide range of options available (e.g., bank loans, lines

of credit, family and friend loans, etc.)

-          Allows you to retain control of your business

-           

Cons:

- Collateral is sometimes required

- Amount you can borrow is usually limited

- If business fails, you still may have to pay back

the money

Equity Financing:

Pros:

- Investors can provide expertise and key contacts

- Usually available in larger amounts than debt financing

- If business fails, you usually don't have to pay back

the money

Cons:

- Investors may demand a say in running your business

- Requires additional time to manage investor expectations

- You forfeit sole ownership of the business and its profits

Debt vs. Equity Financing: Pros & Cons

Common Concerns of Small Business Borrowers

Section 2

While family and friends can be an excellent potential source of financing for your business, as a borrower you may still have some concerns about mixing money with people you know. You are not alone. Below we have listed the top concerns of small business borrowers that we have identified based on our experience.  Underneath each concern we have provided a rationale that should help ease your worry.

1)     Borrower concern: "I am worried lenders will meddle in how I run my business."

How to minimize this concern: By formalizing the loan through proper documentation you will make it clear that this is indeed a loan, and not a favor, which means your lender's role does not extend beyond just that–a lender.

2)     Borrower concern: "I'm concerned that my lender will scrutinize everything I do financially that isn't related to the business. For example, if I take a vacation will they wonder if I'm doing it with their money?"

How to minimize this concern: By setting up a mutally agreed upon repayment plan, your lender will know that you are serious about paying back the loan. Because they will be receiving steady payments, any concerns they might have about how you are spending money should be alleviated.

3)     Borrower concern: "Won’t my lender worry about my business failing?"

How to minimize this concern: Yes, that is a risk they’re made aware of. However, if you secure your loan with collateral, your lender's risk is significantly reduced. In the event that you default on the loan, your lender will be entitled to receive something (e.g., a vehicle, office equipment, etc.) in lieu of being repaid.

4)     Borrower concern: "Even after I pay my lender back, are they going to feel as though they did me a favor, and that I still owe them something?"

How to minimize this concern: By talking to your lender up front and formalizing the loan process, you make it clear that this is a business opportunity, not a favor. By making sure they know that all you owe them is the amount of money borrowed plus interest, you will prevent them from holding the loan over your head in the future.

5)     Borrower concern: "What if I have trouble paying back the loan?

How to minimize this concern: Generally, when you borrow from friends and family, you have more flexibility (compared with a commercial lender) in how you pay back the loan. If you are having difficulty making payments, be upfront with your lender about your situation, then suggest an alternative repayment plan that works for both of you. In most cases, your lender will appreciate your proactive response and accommodate your request.

Many times, family-and-friend loans are often

modified to be more affordable midway

through the repayment term.

Did you know?

 Thinking like a Lender

Section 3

Before you approach someone you know for money, you should first understand the typical loan approval thought process of a traditional lender, such as a bank. This is important for two reasons:

1. The person you approach for money may follow a similar thought process, and you will need to provide the necessary information just like you would to a traditional lender.

2. Even if the person you approach doesn't follow this thought process, by providing  some or all of this information you are demonstrating your business knowledge and professionalism, both of which can increase your chances of obtaining the money you need.

The typical loan approval

thought process:

1. Management Experience &

Expertise. Lenders need to feel comfortable that a borrower has the necessary background and skill set to effectively operate the small business.

2. Detailed Business Plan.

Lenders usually require start-up businesses to have a business plan that includes income and expense projections for the first three years of operation.

3. Cash Injection.

Lenders want to know how much money the borrower has at risk. For start-up businesses, commercial lenders typically require at least a third of the total project costs to be covered by the borrower.

4. Collateral. To reduce their risk in case of default, lenders often require the borrower to secure the loan with collateral. This is usually hard goods such as office equipment, vehicles, etc., but sometimes it can be against accounts receivables depending on the business' current cash flow.

5. Personal Character. In addition to your experience, lenders also try to understand who you are as a person.

As a result, some lenders will conduct background checks that can include looking for any previous litigation or bankruptcy information.

6. Credit History. Lenders like to see a good credit history. If there are any credit issues, an explanation will be

required. Different lenders have different levels of tolerance when it comes to credit issues.

7. Personal Financial Statements. Lenders like to see a list of personal assets and personal liabilities. Do not include debt paid by your business. Include other sources of personal income.

Investments by family and friends account

for more than 50 percent of all investment

dollars for start-ups.

Did you know

Determining Who to Approach for Money

At first, trying to determine who to approach for financing may seem like a challenge.

Many small business borrowers feel they don't know enough people who are in a position to lend them money, and who they are comfortable approaching.

To formulate a list of potential lenders, consider these helpful steps:

• Write down the names of everyone you know, regardless of how remote the relationship. This might include family, friends, colleagues, mentors, teachers, neighbors, etc.

• Circle the names of the people who have some insight into your character and/or personal and business skills.

• Think about a realistic amount of money each person might be able to lend you, and write down that amount next to their name.

Ahmet Ertgun, founder of Atlantic 

Records, borrowed money from his

family dentist.

Consider borrowing from several people rather than trying to get it all from one person. This way, you can ask for

an amount from each person based on what they can afford to give you, and not on what you need.

IMPORTANT BORROWING TIP FACT

Target Lender Target Lender Amount Amount

Description Name Requested Obtained

Elements of a Strong Loan Proposal

When approaching someone you know for money, it is important that you develop a strong loan proposal that backs up your request with facts and figures. Merely asking for the money is practically a guarantee that you will be turned down.

Consider the following:

1. Financing Overview. Show potential lenders exactly how much money your business will require, and tell them what othersources (if any) you are using to obtain financing.Use Worksheet B to determine the start-upand ongoing costs that your business will incur.

2. Legally-Binding Loan Agreement.

Let potential lenders review an actual loan agreement. Seeing an agreement in writing will show your commitment and make potential lenders feel comfortable about giving you the money. Use one of the Sample Promissory Notes to show them

an example.

3. Collateral List. By identifying items you are willing to use as collateral to secure the loan you are demonstrating that your lender's investment is protected. If you will be securing your loan with collateral, use Worksheet C to develop your own collateral list and review it with your potential lender.

4. Loan Type Options. From start-up business loans to seasonal loans, the type of loan you propose impacts how you will repay it. Review the Loan Type Options chart to determine which loan works best for your business situation.

5. Payment Schedule. Based on which loan type you select, review a sample payment schedule to show potential lenders how the loan would be repaid. Use the Sample Payment Schedule.

 

6. Outsourced Loan Servicing. Consider using a loan servicing company to manage the repayment process, which includes payment processing and record keeping. This will reassure your lender that they won’t have to deal with awkward conversations that might inhibit your relationship.

Default rates on informal loans drop from 14 percent to less than 5 percent when a repayment installment plan is used in lieu of a lump sum payment.

Did you know?

Overcoming Common Lender Objections

Potential lenders may object to giving you money for a variety of reasons. Sometimes they may tell you why, other times they may not. Either way, it is important for you to understand these objections so you can respond to them appropriately.

Below are four categories of lender objections, as well as suggestions for how to overcome them:

1)    Financing Objections: These objections typically focus on the lender's financial situation.

Lender objection: "I don't have the money to give you."

Suggestion to overcome objection: Consider asking for a lower amount. Try to find out how much money your lender can afford to give you.

Lender objection: "I can't access the money. It's tied up in an investment, retirement plan, etc."

Suggestion to overcome objection: Encourage your lender to contact their [financial advisor, accountant, etc.]to find out if they can move the money without being penalized. For example, some retirement accounts and annuity plans allow money to be lent to a small business without paying a penalty or taxes.

2)    Business Risk Objections: These objections typically focus on the lender's perception of your business.

Lender objection: "I don't believe your business will succeed."

Suggestion to overcome objection: Review your business plan with your lender to show them why you believe the business will succeed. Consider asking your lender for suggestions on what improvements you could make so they feel more comfortable about your business.

Lender objection: "I don't think you have the skills to run your business."

Suggestion to overcome objection: Emphasize your experience. Talk to your lender about former jobs you've held that relate to your small business, entrepreneurial classes you have taken, or people you plan on hiring.

3)    Relationship Risk Objections: These objections typically focus on the lender's perception of how lending you money will impact their relationship with you.

Lender objection: "I'm concerned that our relationship will suffer if there's a problem paying back the loan."

Suggestion to overcome objection: Recommend using a loan administration company to manage the repayment process. This way, there's a buffer between you and the person from whom you borrow.

Lender objection: "What if we disagree over the terms of the loan after the fact?"

Suggestion to overcome objection: Emphasize that everything will be documented in writing, and that detailed records will be kept–all of which can be handled by a neutral third party.

4)    Outside Pressure Objections: These objections typically focus on external factors that affect the lender.

Lender objection: "My [significant other] won't like the idea of my lending you the money."

Suggestion to overcome objection: Offer to review your loan proposal with your lender's significant other. Also, consider recommending the use of a neutral third party to handle the process.

Lender objection: "I have a friend who lent someone money and never got paid back a dime."

Suggestion to overcome objection: Emphasize that if the loan is set up and managed correctly, the chance of successful repayment is much higher. Additionally, you should stress why you are a good borrower. You might even offer to share your credit history to prove it.

An SBA-sponsored study found that solo entrepreneurs expected their start-up costs to average $6,000.

Did you know?

Summary

The key to approaching friends, family, and other people you know for money is to be open and honest. Focus on the people you believe not only have the resources, but are also likely to have insight into your character and will be interested in your business.

Ask only for an amount that your potential lender will be comfortable giving, and make it clear that a refusal won't offend you or hurt the relationship. Agree to terms formally in writing, and detail how you will repay the loan. Consider using an outside loan servicing company to manage the payment process and maintain accurate records.

Above all, be as business-like as possible.

 

When someone lends money to a small business owner, they are investing in an opportunity.