Alright, now that you are sufficiently forewarned and prepared, let’s discuss how to do it the right way. A huge amount of money is raised from friends and family for investments every year and not every Thanksgiving dinner is being ruined. Obviously, some people are doing it right.
Here are four tips to consider.
Understand Their Motivation
A large percentage of friends and family members’ sole motivation is to help you out. They may not tell you this, and you can’t assume it, but they may even consider their money to be a gift. That said, they may also see their extension of money as a reasonable investment. They believe in you and your project, and if a decent return comes with it, all the better. Ask yourself why they are investing, and tailor your approach to meet their needs.
A key in this is knowing when to say “No.” Within your reservoir of goodwill are some people who will help you to their own detriment. If a friend or family member really can’t afford to help you, don’t even ask.
Be Honest and Transparent
Make sure they know the risks of the investment before you take their money. Explain that not only are you not likely to become the next Google but that they may actually lose their entire investment. Make sure that the money they are providing is money they can afford to lose.
While this may not sound like a very positive conversation to have when everyone is charged up to conquer the world, it is a necessary step. Your supporters will appreciate your candor, and may even continue to socialize with you if things don’t go well.
Consider Taking Money As A Loan
You don’t always have to sell equity in your company. It may be appropriate to borrow the money from friends and family. You promise to pay it back, with interest. And then you do so. Most businesses offer no liquidity, meaning it is very difficult to cash out an equity investment. So even if the business survives your friends’ money is stuck in the investment. By borrowing the money and paying it back, your supporters have helped you get started and you are square with them.
Interestingly enough, friends and family may be more pie in the sky about this investment than you are. They may have visions of $1,000 turning into $1,000,000. You have to be the adult. A loan may be the safer course for them and you need to tell them so. If they really want equity in the company they can buy in at a later round when things are hopefully more stable.
Get Everything in Writing
Be sure to put the terms of your agreement in writing. If it is a loan, a promissory note with an interest rate and payment time frames should be drafted. If it is an equity investment the terms must be spelled out with specificity. The assistance of an attorney is strongly suggested. Be sure that all parties agree to all the important terms and details and then sign and save the agreement.
Many people lament the end of the handshake deal. They ask why everything has to be in writing nowadays. And the answer is because our lives have become too over stimulated with computers, smartphones and television. We are constantly bombarded with new information, new things to process and new distractions. As a result, to expect two people to remember exactly the terms of a handshake deal that was agreed to even two months ago is almost quaint. Certainty is found in well-drafted written documents. This rule applies for all financing methods discussed from here on in.
There’s another reason why putting this agreement in writing is so important: the IRS. If your business doesn’t succeed, your lender may be able to deduct the losses from the loan. But if there is nothing in writing and no repayment schedule, fat chance that will happen. And it gets worse: the IRS may treat the money they lent or invested as a gift, which if the amount is large can create gift tax issues.
Next, we’ll talk about another popular method of business financing that will most certainly involve a contract.
Tapping Home Equity
Just a few years ago, home equity loans were one of the easiest ways to finance a business. Home values were high and lender requirements were lax. That changed dramatically when the housing boom turned to bust. With less equity and much more stringent underwriting by lenders it’s harder to turn your equity into start-up capital.
But these loans haven’t gone away entirely. Seventeen percent of businesses with less than $100,000 in sales use home equity lines of credit for business purposes, according to Barlow Research’s Small Office/Home Office Opportunity study.
There are several ways to use home equity to borrow for your business:
• A home equity loan or line of credit
• Refinance your current mortgage for more than you owe, and take cash out for your business
• Pledge home equity as part of an SBA loan or other small business loan
We’ll talk about the latter option—SBA and small business loans—in Chapters 3 and 4. Here we will focus on the first two options.
As mentioned, it is much harder to qualify for mortgages, including home equity loans, than it was prior to the housing downturn. You’ll generally only be able to borrow up to 80% of your home’s appraised value, minus any first mortgage.
Your personal credit score will be a key factor in determining which program you qualify for, and the rate you’ll pay. Make sure you check your credit reports at AnnualCreditReport.com at least six weeks before applying for one of these loans, to give yourself time to fix mistakes. While you’re at it, check your credit score for free at Credit.com to get an understanding of where you stand. Keep in mind, though, that for mortgage applications, lenders use a specific version of the FICO score which they will obtain with your credit reports from each of the three major credit bureaus. The middle of the three scores that are returned will usually be used for qualification purposes. You can learn more about credit scores in the 2012 edition of Garrett Sutton’s The ABC’s Of Getting Out of Debt (We will refer to several of Garrett’s books throughout the text. Of course, not every related topic can be included in just one book. So the idea is to provide you with an easy reference point for more information.)
Don’t quit your day job just yet! If you are still working a full-time job, apply for a home equity loan or line of credit while you can still show steady employment. Lenders want to see two years of documented income, and it’s become more challenging for those who are self-employed to get these loans. Unless your spouse can qualify for the loan on his or her income and credit score alone, it’s best to get a loan nailed down before go out on your own.
Home equity loans or lines of credit, as well as “cash-out refi’s” may be available from your local bank or credit union, a megabank, online lender or mortgage broker. Shop around by contacting several lenders or using an online portal, or by hiring a mortgage broker to shop for you. Just try to limit applications to a two-week period to avoid possible damage to your credit score that can result from multiple inquiries. (Mortgage-related inquiries within a 14 or 45 day stretch will usually be counted as one, depending on which credit scoring model is used.)
What’s the downside of using home equity to start your venture? The loan will be reported on your personal credit reports and can affect your credit scores. If you pay those loans on time, however, it shouldn’t create too much of a problem. But if you fall behind on a payment on any mortgage loan—home equity or otherwise—your credit scores will likely plummet, at least in the short term.
Another consideration to keep in mind is the fact that home equity lines of credit typically offer interest-only payments for an initial period, called the “draw” period, which usually lasts for ten years, though sometimes it is shorter or longer. After that period, the borrower can no longer borrow against the line of credit, and must pay the entire loan back—interest plus principal—over a set period of time, which may be 10, 15 or 25 years, depending on the terms of the loan. During this latter period, the monthly payment will likely be substantially higher than during the draw period. So it is crucial to understand the term of the loan and what kinds of payments will be required during that time or you may find yourself