Budding entrepreneurs often turn to a lender that overlooks weak points, provides flexible terms, and offers a dream-come-true interest rate: the Bank of Mom or Dad. Without an established track record, start-ups often have trouble getting a traditional bank loan or funding from venture or angel investors. So after tapping their savings, founders often turn to informal investors, which usually means family members and friends.
Such arrangements combine best wishes, a pay-me-when-you-can attitude, and few expectations of a meaningful return. That might be the most realistic view of family and friends financing. So in many cases, it might be wise to not formalize the loan since doing so can raise expectations that it will be repaid in full.
Many people will opt for a loosely structured deal in which, for example, repayment may start only when a company has reasonable cash flow and can afford to make payments — a position many businesses don’t reach until three to five years down the road, if at all. Such an arrangement doesn’t raise expectations of prompt repayment. But such vagueness can lead to problems and confusion later on, prompting some experts to urge putting into writing whether funds are a loan, a gift or an investment. Still, terms of the agreement need close attention. Failure to collect interest or a repayment might prompt the Internal Revenue Service to decide the “loan” was actually a gift and impose gift tax and other penalties.
Online services, such as Prosper Inc. and Virgin Money, a unit of Virgin Group PLC, offer to structure arrangements between borrowers and individual lenders, who are often relatives or friends. For smaller loans, Virgin Money, for example, provides documentation and a payment schedule. For larger business loans, it will service the loans, send payment reminders and provide year-end reports. A more formal plan for larger loans services the loan — including setting up electronic fund transfers, sending email reminders and providing online account access. It also sends out year-end reports to the borrower and lender. The loans are flexible, usually offering lengthy grace periods and interest rates and payment schedules favorable to the business owner.
Some planners note that family members can provide money as an annual gift, helping reduce the size of an estate subject to taxes. Gifts also ease worries of conventional lenders who might be concerned that family loans could impair their ability to collect. One other thought: Some family members who provide loans or gifts think the funds come attached with the right to have a say or participate in the business. Documentation can spell out such issues.
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