Gifts, loans, and equity investments are all options for raising private funds

Learn about your alternatives for generating money from family and friends to fund your business, including gifts, loans, and equity investments.

Small business loans are used by many small business owners to fund their operations. However, with the current tightening of lending rules, business owners may need to look for alternative sources of funding. Money from relatives and friends is a good source of company finance that is sometimes ignored.

When it comes to soliciting money from friends and family, there are three basic financing options: gifts, loans, and equity investments. Learn everything you can about each one so you can make the best decision for you and your possible lender.

Gifts from Family and Friends

The simplest method of receiving business financing is through a donation. You are under no duty to the giver in the future (although you should thank the person and make an effort to maintain good relations). A friend or family member may provide a monetary donation to assist you in getting started, or you may initiate the process by asking. Though it may seem unpleasant to ask for money as a present, it can make sense when you're beginning a business.

A letter noting that the money is a gift is all that is required to document a gift. For tax purposes, the giver should preserve a duplicate to prove to the IRS that the transfer was not an interest-free loan. You should also keep a copy. You can receive a tax-free gift of up to $14,000 per year from any one person. The giver must submit a gift tax return if you receive more than $14,000. (IRS Form 709, U.S. Gift Tax Return). The amount of the IRS gift tax exclusion varies each year; for the most up-to-date rates, visit the IRS website.

Business Loans From Family and Friends

The majority of money borrowed from friends or family is in the form of a loan. Someone provides you money, and you agree to repay it, usually with interest, over a defined length of time and under particular conditions.

Documenting the Loan

It's preferable to set up every loan the same way a bank would: with a documented agreement, known as a promissory note, and a payback plan. Following these business standards will give prospective lenders more trust, and these documentation will safeguard your lender from having the loan treated as a gift by the IRS.

The written documentation should explain exactly when and how you're supposed to pay back the money, as well as what to do if you're late. The promissory note is legally binding once you've signed it.

Choosing an Interest Rate

Friends and family who lend you money are generally prepared to do so at interest rates that are lower than the market rate. They're probably more concerned with assisting you than with making a profit, and some may even insist on receiving no interest at all. However, as you prepare to approach potential lenders, keep in mind that you will have to pay interest for various reasons:

• Paying interest helps you comply with IRS rules for private lending, which treat excessively low interest rates as a gift to the loan recipient that counts toward the lender's yearly tax-free gift limit (see above).
  
• A reasonable interest rate, similar to what your lender would receive on a savings account or CD, may make your lender more comfortable with the overall deal.
  
• Offering an interest rate that is higher than what they would earn elsewhere is a terrific method to capture the attention of potential lenders who aren't as close to you.
  

Considerations When Getting a Private Loan

If you're considering a private loan, keep in mind that you'll have to keep track of it on a regular basis, usually through monthly payments. If your company isn't profitable, this may be challenging. However, if you can't meet your repayment commitments, your private lender is more likely to be flexible than a bank. However, before taking out a loan, you should think about whether you and your company can afford these monthly payments.

Family and Friends as Equity Investors

Selling shares in your company to a "equity investor" is a third approach to raise funds for your company. Although many firms seek professional equity investors, your friends and family members can also invest in your company as equity investors.

How Equity Investments Work

Unlike a loan, who provides you with funds to operate your firm temporarily, equity investors purchase a portion of your company. They become co-owners or shareholders in your company and share in its successes and failures.

Raising funds for your company through stock investments differs significantly from borrowing funds. You'll need to do the following:

• compensate your investors for the risk they've agreed to take on
  
• share ownership in the business
  
• comply with securities laws, and
  
• put all these agreements into a legal document unique to your financing situation, probably with the help of an attorney.
  

Compensating and Protecting Equity Investors

Equity investors take a big risk by investing $50,000 or more in your company with no certainty that it will make money. Your investors should be aware that there is no certainty that they will get their money back.

If your firm succeeds, equity investors will profit handsomely, making the risk worthwhile. If your company expands quickly, investors will make a lot more money than they would if they just gave you a loan and collected interest. Consider the following scenario:

• If a friend loans you $10,000 and you repay it at 6% over 2 years, your friend will make $637 on the loan.
  
• If a friend buys a 10% stake in your $100,000 company, and it then becomes a $500,000 company, your friend's investment will have earned far more than $637.
  

Equity investors can also take steps to protect themselves as much as possible from business failure.

• Equity investors can make sure that they stand a better chance than any other investor of getting their money back if the business goes belly up. They draw up long, complicated legal documents that ensure they will be able to collect a return, sometimes at two or three times the initial investment, leaving other less-privileged company co-owners (like you) with nothing.
  
• Equity investors can stay informed and involved in your business by, for example, taking a seat on your board of directors or requiring reports on both financial and operations matters.
  

Sharing Ownership in Your Business

When you invest in equity, you're dealing with a joint ownership situation. Your investors will have a say in how your firm is run. This isn't to suggest you shouldn't invest in stock, but you should be aware of what you're getting into.

Documenting an Equity Investment

To formalize an equity investment in your company, you'll need to produce an equity purchase agreement and other documentation. Because this paperwork is complicated and will define who owns and manages your firm, you should probably seek legal advice.

You may also need to follow federal and state securities regulations, depending on how many investors you attract and how much money you raise. To guarantee that you comply with these rules and deal with the necessary paperwork, you will almost certainly need to engage an attorney.

Finally, you should research how having investors will affect your tax filing, and you should notify your investors on the tax implications of their investments.

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