Is it wise to borrow from family or friends for your business?

Business owners approach family or friends to help finance their business for a range of reasons. It might be that there is an immediate opportunity, but there isn’t the time to go through the process of applying for a bank loan or it might just be that the bank has said “no”.

Whatever the reason, borrowing from family or friends is increasingly common these days and with interest rates at historic lows, there are cashed-up individuals looking to lend to and/or take equity positions in businesses owned and managed by people they know and trust.

But is borrowing from family or friends really a good idea?

A significant added dimension here is that if the business doesn’t do well and the loan can’t be repaid you will experience angst and pain both on a business front and a personal level. It’s hard enough for an owner to deal with a struggling business, but the added burden of managing a relationship with a family member or a friend who has lent money to your business makes things even tougher.

When your business borrows from a bank the bank will almost always insist that you provide a personal guarantee. Banks take personal guarantees to provide a fall back in the event of a default where the bank is still out of pocket after the assets of the business are sold. You should only ever give a personal guarantee if you are prepared to accept the worst case possibility of the bank taking all your assets and even making you bankrupt if you can’t repay the full debt plus any penalty interest and fees.

If a family member or friend lends money to your business, will they ask for or will you offer to provide a personal guarantee? What would happen to your relationship with the lender (as well as partners, spouses, children, friends, etc) if the lender called on the guarantee in the event of a default. Few families and friendships come out of these challenges unscathed.

So is borrowing from a family member or friend a “no go” area? Not necessarily. It can and does work. We recently encountered a situation where a business owner who was under pressure from his bank entered into a short-term borrowing arrangement with a well-heeled friend to buy time whilst the business was restructured and returned to profitability. In this case it worked out well because the friend was refinanced with bank debt once the bank was satisfied that a profitable trading record has been re-established.

How to protect both parties

Whilst there are risks in doing business with family or friends, such arrangements can be beneficial to all parties, although it is crucial that all aspects are clearly understood and formally documented.

What security is offered and interest rate you pay will be negotiated between the parties. If you can’t get a loan from the bank it suggests you should pay a higher rate, but your potential lender might not want or need to be compensated in such a manner. You could consider other options like issuing equity as an alternative to having the loan repaid.

But it is very important to be clear as to the rights of the lender. A lender is not an equity partner, which means they are not entitled to share in the profits of the company or the uplift in its value even if this has been achieved as a result of the funding they have provided.

Equally, the lender shouldn’t be expected to carry any losses the business makes. As a creditor, they are entitled to have their debt serviced and repaid before any return of capital or profits to the shareholders. So both sides need to be very clear as to the true nature of the support the family member of friend is providing.

There are always risks in borrowing, whether it from a bank or a family member or friend. The important point is that all parties fully understand these risks and formally document how the arrangement will work.

Neil Slonim is an independent business banking advisor and commentator. He is the founder of theBankDoctor.com.au an online resource centre designed to help SMEs understand, quantify and mitigate their Bank Risk.