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Recent surveys suggest that one in ten businesses currently use close friends and family as bankers.

A business plan will help you to pitch to them. It is important that all parties concerned are clear about the investment, the length of time the investment is required, the risks associated and when any income is likely to materialise. Explaining this upfront can help prevent relationships going sour due to misunderstandings.

There are generally two ways to invest, through a loan or share of equity. An interest-bearing loan will have tax implications for the lenders if they decide to fund your business. A share-of-equity investment means you will be giving away part of your business, which has its advantages and disadvantages. This is usually the route to go down if your business requires longer-term investment.

It is important to manage expectations. If an equity investment is being discussed, then it should be explained that it is risk capital and therefore the lenders may not get all their money back. It is also worth discussing how achievable repayment terms may be reached. A formal agreement should also be considered.

This will include:

  • the nature of the loan or investment with repayment terms or share of the business
  • responsibilities of all parties
  • details of how problems will be resolved.


Common use

Finance from friends and family is often used to finance start-ups or relatively new businesses.

Costs
There are three main direct costs that need to be considered:

  • producing a formal agreement
  • interest (if applicable)
  • professional advice.

The cost of obtaining finance from friends and family is relatively low. It may rise if the business arrangements become more complicated. If a formal agreement is complex, then it may need to be drafted by a professional. Fees will vary depending on the complexity of the business, its size and risk.

Interest, if charged, will vary depending on the risk of default. The most common types of interest rate will be fixed or variable, sometimes with reference to the official rate of interest.

Legal fees will vary depending on if other services are provided, the complexity of the business, its size and risk to the lender. Fees are likely to apply when a personal asset, such as a jointly owned property, is provided as security.

Fees will vary depending on whether other services are provided; bookkeeping, for example, and also on the complexity of the business, its size and the frequency of issue.  

Timeframe
The timeframe for arranging a loan will vary. If the business is ready, funds are liquid and discussions are already taking place, then finance could be available within one to four weeks. It may take longer if the finance from friends and family is not in a readily accessible form. Timings will also depend on whether new security, new valuations or legal advice are required.

Advantages

  • suitable for short- to medium-term borrowing needs
  • friends and family can be more willing to lend, especially where other types of finance are not accessible
  • terms agreed with friends and family are often more favourable than those from commercial providers
  • loans and investment terms can be flexible and cover a longer repayment period than is usual with commercial finance
  • as friends and family know you well, you will not usually need to provide references
  • once this type of finance has been obtained, commercial finance may be easier to get hold of
  • the credit will usually not be secured.

Disadvantages

  • decisions may be based on emotion rather than business sense
  • control may end up being diluted when it is not best for the business
  • business failure would mean friends and family losing money
  • a default on loan repayments would affect personal relationships
    there are tax consequences to the lender if interest is charged
  • even if interest is not charged, the lender will need to consider the consequences of inheritance tax.

Other options
The right finance for your business section of the site gives examples of financial structures that are suitable for different trading types and sizes of business.

Finance from friends and family is a common form of finance, like trade credit and overdraft facilities. There are different types of loans available, including mortgage and offset facilities.

For short-term needs, such as managing your cashflow, an overdraft or business credit card may be more suitable options. 

Where loans from friends and family are used to finance assets, hire purchase / leasing should also be considered.

Last updated: 22 Jun 2012