Borrowing Startup Capital from Relatives

For most entrepreneurs, their startup venture is not a likely candidate for a bank loan. Many entrepreneurs turn to family members to fund or to supplement funds for a startup.

Accepting money from relatives has its own unique perils for the entrepreneur. Involving family in your venture may or may not be a smart move.

Here's a few general guidelines to contemplate when considering approaching a family member about funding your business:

1. This option should be a last resort. Borrowing from family can reduce the relationship to a financial transaction and has ruined many family relationships. Make sure you have exhausted all other options from crowdfunding, to micro lending to an equity investment from a partner before turning to this source of funds.

2. Pick your relative carefully. Don't ever pick your source of capital simply because they have the funds. Do you genuinely like this family member? One thing I've learned from watching others do this is that involving money between two family members will magnify the relationship that is already there - good or bad. Life is too short to be in business with someone you detest, just because they have the money you think you need. Try to pick a family member who is willing to invest in you who has some history and experience in business for themselves. A seasoned business owner's advice and direction may actually be more valuable than the money you borrow from him or her.

3. Is it a loan or an equity investment - or both? It's one thing to owe money to a family member, it's quite another to have them own a piece of your business. Sometimes, there can be a combination of the two. The entrepreneur needs to be prepared to for the family member who may want an ongoing concern in the business, which may conflict with your ownership plans.

4. Execute a loan or equity document. One thing is for sure when it comes to borrowing money from family, there will be two (or more) stories about how the loan was supposed be repaid and what the original terms were. When I lend to an individual or family member, I am very strict about what the use of those funds. Without a fully executed loan or investment document, the interpretations blur over time and circumstances. It's worth a few hundred dollars to have a legal document drawn up. Make sure it includes a "confidentiality" clause unless you want all of your third and fourth cousins to be able to chime in with their "opinions". The repayment plan should be crystal clear. If the investment comes with equity in your business, you should also have a prepared "divorce" document known as a buy/sell agreement that specifically dictates how you can buy them out, whether they want out or not.

5. Set expectations with your family financier. Make sure your family investor is fully aware of the business plan, the risks and your path to profitability.

6. Set rules of engagement. There's nothing worse than a "hoverer" who is looking over your shoulder at your every move. Make sure your family lender knows his or her place in the business and if they have a day-to-day role or not.

7. Don't borrow someone's life savings. It's one thing to risk your own life's savings for a startup you really believe will be a home run, but borrowing your grandma's life savings who is living on a fixed income is extremely risky. Generally speaking, whatever you borrow from a family member should be an amount they are willing to risk and lose completely.

8. Pay off the loan BEFORE purchasing lifestyle. There's nothing worse than lending money to a family member, only to see them get into lifestyle debt (new car, home, jewelry, clothes, etc.). Absolutely do not spend any of these funds on anything other than what is documented for in the use of funds section of the loan or investment document. When the business starts cash-flowing, this debt should be the number one item in line to get paid off first without exception.

Family members will continue to be a main source of funding for the bootstrapping startup. But, just because it may be a family member doesn't mean it shouldn't be treated as a professional transaction. Properly documenting the transaction protects both parties and thus the relationship so that it is beneficial for both!

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