Getting the family to invest in your business

Getting the family to invest in your business – 1993 Money Management Guide

Patricia M. Carey

Five years ago, when Babette Peyton of Chicago founded Peyton Elevator Co., an elevator installation, repair and inspection company, she bypassed banks and appealed to her mother, Rosette Peyton, for start-up capital. Rosette loaned her $17,000 from savings and $30,000 from a home-equity loan. Over the next five years, she chipped in an additional $100,000 from her school-teacher’s salary.

Today, the young company is still not profitable (although Babette predicts it will be this year), and she has repaid Rosette only $1,500 of the $147,000 she owes. But Rosette’s faith in her daughter remains unshaken. “I believe very strongly in Babette,” she says. “I know she will succeed.”

In today’s brutal credit environment, there’s no substitute for that kind of faith. As banks and government regulators tighten the lending screws, more and more entrepreneurs are turning to friends and family for start-up capital. The advantages are obvious: Personal relations make sympathetic bankers, repayment terms are usually flexible and red tape is minimal.

Borrowing from friends and family is a particularly popular option among African-Americans, who often lack easy access to other sources of cash. In a recent study by the Kessler Exchange of Northridge, Calif., 36% of African-American small-business owners sought financing from friends and family compared with just 24% of whites, 29% of Asian-Americans and 23% of Hispanics.

Yet borrowing from personal relations carries enormous risks. Statistics show that most small businesses fail, often leaving behind substantial debts. If you can’t repay a financial institution, your credit rating suffers. If you can’t repay Aunt Agnes or Cousin Tyler, the consequences can be far more personal – and painful.

Even if a business flourishes, personal relationships can suffer. What if a relative helps you out when you’re a struggling entrepreneur? When the company strikes it rich, the family member may expect a piece of the action. According to A. David Silver, president of ADS Financial Services Inc., a Santa Fe, N.M., investment banking firm, “The problems of success [can be] even worse than the problems of failure because of the greed factor.” That is, unless you take the proper precautions.

Small-business financing experts say problems often stem from agreements that are unwritten, incomplete or vaguely worded. “People want to demonstrate their level of trust by allowing these transactions to be very informal,” says Thomas D. Davidow, a principal of Genus Resources Inc., a Needham, Mass., family business consultancy. “But the lack of formality enhances the risk. People don’t realize until later that they have very different expectations about what’s going to happen.”

Does that mean you shouldn’t borrow from friends and family? No. But it means you should take particular care in how you structure these arrangements. Think of it as giving your homegrown financier the same kind of attention you would a bank lending officer or a wealthy stranger.

Provide A Business Plan

If your friend or relative is undecided about financing you, a good business plan can tip the decision in your favor. Be sure to spell out what you’re going to do with his or her investment and how you’re going to make enough money to pay it back. “Formalize the business so that you’re making decisions based on real numbers, not intuition,” says Don A. Schwerzler, a principal of the Family Business Institute in Atlanta.

A business plan improves your chance of success. It forces you to articulate a long-term strategy, and makes it easier to identify potential trouble spots. Geoffrey Kessler, founder of the Kessler Exchange, suggests taking the plan to local bankers even if you’re sure they won’t lend you money. Why? Because conservative bankers are very good at spotting flaws. “If you’re only talking to friends and relatives, you’re not getting objective advice that might keep you out of trouble,” Kessler advises. If you’ve never written a business plan, read a book on the subject or contact your local Small Business Administration (SBA) center for help.

Structure The Investment

Once your investor has agreed to come up with the cash, you have to decide on the structure of the investment At one extreme is a straight loan that will be paid back with interest At the other is a straight equity investment, where the investor’s cash buys a piece of the new company.

Between these two options, there are endless variations. You might, for example, give a lender warrants entitling him or her to buy shares in your new company at a set price.

Friends or family members will often feel uncomfortable hashing out this issue. Typically, they are backing you for personal reasons, and may feel that a discussion of financial terms indicates a lack of trust or generosity. Therefore, you should bring k up yourself. If you air this issue at the beginning, your investor may be grateful later on.

Consider this: In 1989, when Pierce and Rosalind Grant-Clifton of Chicago told their friends William and Anne Tucker they wanted to open a temporary employment agency, the Tuckers immediately offered to lend them $15,000. “I had the money available,” remembers Anne, who is president and CEO of a $5-million nurses temp agency. “I knew Rosalind’s experience, and I had no doubt she would be successful.”

The Cliftons parlayed the loan into Backlog Ltd. – with expected billings of $1.3 million this year – and repaid their friends within a year at the agreed-upon rate of 2% over prime. Everyone was happy but in hindsight Anne wishes she had asked for an equity stake in the company. “I really didn’t see it as a business venture,” she says. “They were friends and we just went ahead and did it I’m not angry because I didn’t think of it at the time. But I wish I had.”

Put Everything in Writing

Small-business financing experts are unanimous on one piece of advice: Put everything in writing. Written records are necessary ff you are eligible for a tax deduction on interest. They also will help the lender justify bad debt deductions if the loan is not repaid. And they’ll make it easier to line up financing when you’re ready to expand later on. .

“Your relative [or friend] might say a written agreement’s not necessary, but you should do it anyway,” advises Bruce Blechman, president of the Capital Institue, a small-business financing consultancy in San Mateo, Calif. “When money changes hands, you need an agreement that spells out obligations and responsibilities,” adds Blechman, co-author of Guerrilla Financing: Alternative Techniques to Finance Any Small Business (Houghton Mifflin, 1991, $10.95).

In Lancaster, Calif., the seven Jones siblings and their parents bought AV Secretarial Services with a $16,000 loan from a brother-in-law. “We didn’t have a written agreement because we didn’t know anything about business,” says James H. Jones. “It didn’t cause any problems because we’re a very close family.”

But as the business has grown – the family recently bought a health food store with a $10,000 loan from their father – James, who manages both companies, is realizing that even close families need to write things down. “I understand now that it’s business and if something goes wrong legally, or if anything happened to me, we really need to have everything on paper,” he says.

Many entrepreneurs and their relations resist written documentation because they see it as unnecessary red tape. But keep in mind that a friend or family member is going out on a financial limb for you, and may not be sufficiently sophisticated to understand the risks. The best way to show your appreciation is by crafting an agreement that looks out for their interests.

What Goes In The Fine Print

From a legal point of view, the agreement should be as detailed and specific as possible. Realistically speaking, however, your relation may feel uncomfortable – with or even, insulted by – a lengthy document full of lawyer’s jargon. The more businesslike you make the agreement, the better, suggests Kessler. “But often that’s not possible. Just understand the risks and do what you can,” he adds.

If you prefer to draw up a simple agreement yourself, it’s wise to have it reviewed by a lawyer. Whether the agreement is complex or simple, make sure you’ve considered the following:

* A loan agreement must include such basics as the amount of the loan, the interest rate and specific terms of repayment. Consider structuring repayment terms to vary with the amount of income coming into the business. In Babette Peyton’s case, the original loan was a balloon with all principal and interest due at the end of five years. The agreement also specified that if the company had an operating profit of 20% or more for six consecutive months, then 25% of those profits would go toward the loan.

* Spell out what happens if you can’t meet the terms of the investment or if the business fails. Discussing the possibility of failure is difficult but necessary, particularly if the investment represents a substantial part of the lender’s personal wealth. The Cliftons, for example, offered a personal guarantee to their friends the Tuckers. If the business had failed, the Cliftons were pledged to repay the loan over five years. Another alternative is to structure the loan as a convertible debenture, a loan that can be converted into stock in the company if the borrower fails to meet the terms.

* Have an accountant review the agreement for tax consequences. A key issue is the rate of interest charged on loans, notes Elda Di Re, senior manager in Ernst & Young’s individual tax practice. Any interest received by the lender is taxable. For loans over $10,000, the lender may also be taxed on what the internal Revenue Service calls “imputed interest” – the difference between the interest rate charged and what the IRS considers a market rate. Ask your accountant or tax professional for the applicable federal rate (AFR). AFRs vary from 3.95% to 6.61%, according to the term length of the loan.

* Plan for disaster. Consider what would happen in a worst-case scenario, such as death or divorce. “You might secure a loan with a life insurance policy making the lender the beneficiary,” suggests Howard Neiman, a CPA and principal of the Family Business Institute. That way, if you die, the lender gets paid. In the case of an equity investment for example, your agreement should spell out whether the investor’s stake is transferable and under what conditons.

* Plan for the long run. Don’t give away too much equity in the start-up phases or you may have trouble raising money for expansion later on. In one case, a man invested $80,000 for an 80% stake in his son-in-law’s attempt to develop a new computer chip, recalls investment banker Silver. When the company needed to raise more money, there wasn’t enough ownership left to attract venture capitalists until Silver convinced the father-in-law to give up some of his share. “If it’s truly seed capital, it should act like seed capital,” Silver says. “It should bring the venture up to the point where its ready for the next round of financing and growth.”

* Anticipate interference. It’s natural for a lender to want to stay informed about your progress. its probably a good idea to schedule regular meetings to update your financial backers. But some investors may also press for an active role in decision making. You have to decide at the beginning whether this kind of participation is welcome. One possible pitfall is that an overcautious investor with a say in decisions may hamper your ability to take the entrepreneurial risks required to succeed.

Clarify up front how much participation in the business the investor is allowed. “There must be rules of entry,” says Schwerzler. “If they say, ‘I’ll lend you money but I want to come along with the money,’ then you should have a written job description.” The same approach applies, even for your best buddy. Remember, business is not about love and kinship; it’s all about making money.

COPYRIGHT 1993 Earl G. Graves Publishing Co., Inc.

COPYRIGHT 2004 Gale Group