The Hidden Costs of Financing from Family

My column in today’s Tennessean looks at the challenges of taking financing from family:

In good economic times, 85 percent to 90 percent of capital for small businesses comes from friends, family and the entrepreneur’s own funds.

But during times of tight credit or recession, family members may be one of the few sources of funding for most startup entrepreneurs.

When taking funding for a business from family members, it’s critical that everyone involved fully understands what they are getting into.

Family members provide funding for many reasons. Some are motivated by altruism — they just want to help the entrepreneur get started and be successful. Others can be driven by greed — they see the investment as a way to ride on the entrepreneur’s coattails to fortune and fame.

But no matter what the reason for a willingness to provide financial assistance, defined boundaries and clear expectations must be clearly established.

Here are some rules of the startup road:

• Never take money for a business from a family member as a “gift.” It should be treated either as a formal loan or investment.

Present the interested family member with a formal business plan, which should be discussed in full detail.

• Any loan from a family member should have a formal loan agreement that defines interest rate and payment terms. To help the entrepreneur, payments can be delayed, but interest should accrue during this time and eventually must be repaid.

The Internal Revenue Service publishes the current minimum interest rates at its Web site, www.irs.gov/ (just enter “interest rate” into their search feature).

• Do not structure any loan without interest. There can be tax consequences for all involved if such a loan is not set up with acceptable interest charges.

• If the money comes in as an investment, the family member is now the entrepreneur’s partner. This means they have certain rights that any shareholder has in a privately held business, which can include approving certain major decisions, such as the sale of the business.

Send reports

All investors should be provided with complete financial data at least once a year.

If the business makes a profit, they probably will owe taxes on this profit. All of this must be made clear before any investment funds are accepted.

Whether the money is treated as a loan or an investment, the entrepreneur should regularly communicate good and bad news. Provide regular quarterly or even monthly summaries that include any significant accomplishments, challenges and major events.

All of these steps will help keep issues that are business related as strictly business, and issues that are family as family matters. After all, Thanksgiving comes every year. Don’t let a business deal spoil the family dinner.