Lending to family, friends has pitfalls, but plenty of upside
Jayne O'Donnell - Gannett News Service Printer Friendly
"Friends and family" investments are increasingly popular given the limited capital and credit available.
Banks have raised credit requirements, homes don't have the equity they once did, and start-ups seldom have the assets professional lenders seek when they're doling out loans, said Cap Willey, a certified public accountant with CBIZ Tofias in Rhode Island.
In a July poll by the National Small Business Association, 43 percent of small businesses reported using bank loans to finance their businesses during the previous 12 months, down from 53 percent a year earlier. An additional 19 percent used loans from friends and family over the past year, down from 20 percent in July 2009 but up from 12 percent in August 2008.
Given the paltry interest rates being offered on bank certificates of deposit, getting 3 percent to 4 percent interest on a loan to your second cousin may sound like a great idea. But while it may be safer than forking over cash to a stranger, friends and family investments are not without risks.
Experts advise you to treat the deals like the business transactions they are.
For example, an interest-free loan could create tax issues - including gift-tax problems - so a tax professional should be consulted. The loans should carry a rate of at least the IRS Applicable Federal Rate, which is published monthly by the IRS. You can find the rate at www.irs.gov.
Willey suggests charging more if it's a loan seeking a decent return, as opposed to a favor. A loan to an undercapitalized new venture could easily carry a rate of 10 percent to 15 percent, he said. And it could also convert to equity or have warrants that would allow the lender to take an equity position at an agreed-upon price at a future date.
There's the potential for personal problems and financial trouble when it comes to lending to those close to you.
Slow repayment or nonpayment can fracture relationships with family and friends, who are often just the people borrowers need when times get tough, the experts say.
When businesses fail, owners often need support "like there was a death in the family," said Kevin Ayres, a hospitality finance and strategy instructor at the University of South Carolina. "The problem is that the ones they are most likely to turn to are the ones they most likely approach to borrow money, and this leaves them in an even more difficult situation."
So how to reap the benefits while avoiding the risks? Consider whether you can afford to lose the money, said Willey, whose clients include small-business borrowers, lenders and investors. He recommends getting everything in writing. However, a promissory note has no value unless it follows state laws. Promissory-note fraud is one of the leading violations pursued by state securities officials, according to the North American Securities Administrators Association.
Willey said he's seen promissory notes that include personal guarantees such as second or third mortgages, but they are difficult to collect when families are involved. To protect yourself, consider running any deal by both a lawyer and an accountant, he said.
When agreements aren't in writing, there are often disagreements over the interest rate or payback schedule, Ayres said.
Julie Cropp Gareleck, who owns a business with her parents and sister, says family members are the only ones she would trust to run her business. But when it comes to lending money, she cautions that goals, roles and responsibilities need to be clearly defined in writing, along with an "exit strategy."
