Two-thirds of the credit applications submitted by business owners in New York’s Tri-State Area were denied in 2011, according to the Small Business Borrowers Poll released by the Federal Reserve Bank of New York. Among those whose loans were approved, only 13 percent of applicants received the full amount they requested.
Given the difficulty of borrowing much-needed capital from banks, some small-business owners are turning to friends and family for cash infusions. If you decide to go this route, here are some tips for doing so, as well as some risks to consider when asking loved ones for a loan.
1. Disclose all pertinent information. When you’re applying for a business loan, your financial institution has the ability to calculate the risks. But when you’re dealing with friends or family, they’ll often have only your input on which to base their decisions. When you’re talking about your startup or existing business, it’s easy to focus on positive numbers; however, it’s important to present potential lenders with all of the data, just as you would to bankers. If things don’t turn out the way you envision, withholding information could add tension to your relationship if lenders think you failed to disclose details that may have otherwise affected their decision.
2. Don’t be lax in your presentation. Just because you’re meeting with people you know, that doesn’t mean that you can be casual in your presentation. Set a professional tone for the meeting and bring your business or expansion plan, sales projections, cash flow statements, and a detailed outline of the loan that you’re requesting. If your documents aren’t up to date, or if you’re just starting out and need to create them, go to SCORE’s website for free templates that you can use.
3. Prepare a legal document. No matter how good your relationship is with the lender, it’s always possible that there will be a disagreement or misunderstanding about the loan. In order to avoid this, make the loan legal with a promissory note. You can buy pre-printed promissory notes at Nolo and FindLaw and create your own terms. You can also go to LoanBack, which will create customized loan documents and amortization schedules, figure interest calculations, keep track of payments, and even send late notices. This will allow you to separate your business dealings from your personal relationship.
1. You won’t be able to repay the loan. Life is messy and often beyond our control. You may become sick or injured, or the market may turn and your business may crash. If the unexpected happens and you can’t repay the loan, it could strain your relationship. Avoid problems by putting up collateral equal to the amount of the loan, so if the worst happens, your lender won’t be left in a lurch.
2. The lender wants to have a say in your business. Because they have skin in the game, the people lending you money may assume that they’ll be involved in the decision-making processes for your business. This can lead to hurt feelings and worse when you don’t agree with their ideas. Avoid this by clearly stating in your loan agreement that you are solely in charge of running the business and that they have no input in the business decisions.
3. You miscalculate the tax implications. If the loan includes interest, you’ll be able to claim a deduction, but the lender will have to claim it as income. This can get someone in trouble with the IRS unless it’s understood from the beginning. Avoid any issues by making sure the lender understands the tax requirements associated with the loan.