True story—starting a business ain’t free.

And unless you have a Leprechaun showering you with gold coins, you may need to borrow a little something-something to get your business off the ground.

While some new business owners go the traditional small business loan route, others skip the big banks and borrow directly from friends and family. Borrowing from people you know is a more intimate experience and often allows you to pay less in interest and loan fees.

But when things get TOO casual, conflict begins.

Even though borrowing from friends and family is usually less formal, that doesn’t mean business owners should skip the steps that set them up for repayment success.

When I went to coaching school, I borrowed money from my partner. Since we lived together, the loan agreement was VERY informal. Instead of signatures, we kissed on it!

In hindsight, I wish I had been more intentional about the whole thing. Not only for my partner’s sake, but for my own business finances. If I had been more thoughtful about my borrowing, I would have been realistic about when I was going to repay her—avoiding some awkward post-dinner conversations.

Here are the top lessons I learned after cringing through those uncomfortable money chats.

What I Wish Someone Had Told Me Before Taking a Friends-and-Family Business Loan

1. If you’re borrowing from family, make sure you’re being charged interest.

[Skip this section if you’re thinking about borrowing from a friend.]

Let’s say a family member wants to give you an interest-free loan. Sound too good to be true? It is.

If your family member doesn’t charge you interest, the loan is seen as a gift by the IRS, and it is taxed as such for the lender. Plus, it’s seen as income for you, the borrower. You don’t want that.

Instead, make sure your family member charges you a rate that’s at least the IRS’s applicable federal rate, called AFR. AFRs change every month, so be sure to check the IRS AFR table when you’re putting together your family loan agreement.

Annual IRS Applicable Federal Rates for September 2018

– 2.57% for short-term loans that have repayment terms up to three years.

– 2.63% for mid-term loans that have repayment terms between three and nine years.

– 2.91% for long-term loans that have repayment terms over nine years.

Loans and gifts are very different animals, and you want to keep them as separate as possible. If you have any questions about the tax implications of borrowing from family, check with your CPA before putting anything in writing.

2. Don’t offer to pay the loan back right away.

The reality is, you’re not going to be able to pay back a loan right after you start your business. Here’s a quick lesson on why that is:

Even if you’re bringing in revenue, in the early stages of your business you’re still learning how to stabilize your cash flow.

  • Cash flow = all the money that comes in and goes out of your business in any given period of time. It is the literal CASH you have in your business, not hypothetical money like open invoices or payments you’re waiting for.

There are two parts of cash flow: inflow and outflow.

  • Inflow is the cash that comes into your business, like revenue and money that you borrow.
  • Outflow is the cash that goes out of your business, like business expenses, owner pay, and loan payments.

Cash flow is NOT the same thing as profit. You can be profitable but still have a negative cash flow, which means you have more cash going out than coming in. How’s that possible?

An example:

– Your business brings in $5,000 in revenue the first month, and you spend $2,500 on business expenses. That leaves you with $2,500 in profit. ($5,000 – $2,500 = $2,500)
– So if you take a $2,000 owner’s draw to cover your personal expenses, that leaves $500 in your business account. ($2,500 – $500 = $500)

– You have a $1,000 loan payment due, and you only have $500 left in your account. ($500 – $1000 = -$500)– That means you don’t have the cash on hand to make your loan payment.

On paper, things look like they’re going great. You’ve got profit and can make a living off of your business. But in reality, your business cannot repay its loan.

This is exactly what happened to me. After I finished coaching school I had clients, but I wasn’t profitable enough to pay my rent and repay my loan.

When you borrow money from friends and family, it’s important to build in a grace period where you aren’t expected to make loan payments. This gives your business a chance to stabilize its cash flow after paying off your initial startup expenses. It also allows you to learn about your cash flow patterns.

The more in tune you are with these patterns, the easier it’ll be for you to make sure you don’t come up short when you enter your repayment period.

How long should you wait before paying back your loan?

Ideally 12 months or more, but at the very least, six months.

I’m not trying to be Debbie Downer here, but it’s unlikely you’re going to be able to launch a business, get a bunch of clients or sales, pay yourself, and pay back your loans by your third month. Even if you can, use the grace period to build a financial cushion so you never have to worry about defaulting on your loans.

3. Stagger your repayment schedule.

If you’re borrowing money from multiple friends or family members, staggering your repayment schedule is a must. Why? Because it’s another way to ensure that your business will have healthy cash flow during your repayment period.

Staggering repayments is when you don’t pay off a loan all at once—you spread out your repayment timeline.

If you offer to start a 24-month repayment term on all your loans after a one-year grace period, you’re going to be draining A LOT of money from your business fast. Instead of offering your friends and family the same repayment terms, stagger the repayment periods and amounts based on the total loan you take out.

For example, you could start paying off smaller loans first while your business is building momentum and tackle the larger loans later.

Or you can pay smaller loans over a more immediate 24-month period, and larger loans over five years. The goal of staggering your repayment periods and amounts is to have a sustainable repayment schedule so you don’t need to borrow more money or default on your payments.

Here’s what a staggered repayment schedule could look like for a business owner who takes out three loans of various amounts:

  • Loan #1 for $1,500: Repayment starts after 1 year with a 24-month repayment term ($62.50/monthly payment).
  • Loan #2 for $5,000: Repayment starts after 2 years with a 36-month repayment term ($139/monthly payment).
  • Loan #3 for $10,000: Repayment starts after 3 years with a 60-month repayment term ($167/monthly payment).

Repayment schedule example

YearMonthly PaymentLoans in repayment
Year 1 $0none
Year 2 $62.50Loan #1 ($62.50)
Year 3 $201.50Loan #1 (62.50)

Loan #2 ($139)

Year 4 $306Loan #2 ($139)

Loan #3 ($167)

Year 5 $306Loan #2 ($139)

Loan #3 ($167)

Year 6$167Loan #3 ($167)
Year 7$167Loan #3 ($167)
Year 8$167Loan #3 ($167)

Worried about taking eight years to pay off your loans? Speed up the process by paying an extra $139 per month on Loan #3 in Year 6 and for the first seven months of Year 7. You’ll shave 17 months off of your repayment term. And your friends and family will LOVE you for being so proactive.

Borrowing from friends and family doesn’t need to end in high drama. Doing a little prep work before you ask not only boosts the odds of your friends and family saying yes, it also maintains your relationships with your loved ones.

Who knows, you may even convince them to dress up like a Leprechaun and throw gold coins at you—all while helping your business dreams come true.

Andi Smiles Andi is a small business financial consultant and coach who teaches business owners to take control of their finances. She’s helped hundreds of self-employed folx organize and understand their business finances, while also uncovering their emotional relationship with money.
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