Think Twice Before Borrowing from Family

Small-business owners who ask relatives for money often run into a host of problems, say experts

by Zoe Galland

The situation is deceptively simple -- a would-be small-business owner has difficulty finding enough money to start his company. Perhaps he has bad credit and the bank denies him a loan. Perhaps he's inexperienced at running a business and unsure where to turn for funds. So, he calls up his father, mother, or a close friend and asks for their support. What could go wrong?

More than he knows. Borrowing money from family members is a complicated process fraught with tension, and business owners who choose to do so must consider the possible repercussions.

PREPARE FOR PROBLEMS.

Family business advisor Paul Karofsky, who formerly contributed a column to BusinessWeek Online, says borrowing from one's family is very different from a straight business relationship. "It's risky business to borrow from family members," Karofsky says. "It needs to be a last resort, not a first resort. Family members need to know you've exhausted all other possibilities."

With families, Karofsky says, "We value people for who they are." In the business world, it's about "what people do and how well they do it. The incompatibility of these systems can create enormous stress."

Al Korn, the chairman of the Small Business Administration's (SBA) Counselors to America's Small Business program (SCORE), agrees that there are many risks involved in failing to repay family members on time. "A banker will send you a nasty letter," he says. "A relative will remind you [about the money] every time they see you."

TABLE TALK.

Karofsky stresses that there must be clarity about whether the money involved is a loan or a gift, and that a written agreement of some kind should always accompany any money lending. If a family member makes a loan, he says, it should be clear what kind of interest it carries.

Personal issues become tricky, he says. How often is it O.K. to talk about the loan at family gatherings? "There need to be some boundaries," Karofsky says. "Is this something you talk about on Saturday night when you're at dinner together? This is a real, legitimate business transaction."

People who do choose to borrow money from family members -- after considering the unpleasant factors involved -- can still be successful. After all, when there are no other options for someone who wants to start a business or keep their business open, family members are always there.

WINNING TEAM.

"Of course it's not ideal," says John Miller, a spokesman for the SBA's New York District Office, "but if you don't have good credit, for example, you won't get a loan from anyone else." As a first resort, he says, a prospective business owner usually uses his or her own personal funds, and then credit cards. After that, people tend to go ask relatives and friends.

Josh Kalter, who worked for a large international trading company before he decided to start a metals business, is one success story. After consulting with SCORE counselor Max Wagner, he decided to both use his own money and have his father and brother-in-law help him out. They opened up certificates of deposit at the bank, which then extended lines of credit against the CDs. That way, Kalter says, "the money is guaranteed."

"If I were to default," he adds, "they would take money out" of the family's account. Kalter's startup, Network Metals, is now a successful small business in New York, importing metals and representing foreign metal producers in the U.S.

EARNING CONFIDENCE.

A report released by the SBA's Office of Advocacy showed that entrepreneurs starting a company alone believed they needed around $6,000 to launch it. The report also stated that 8% of these businessmen planned on seeking bank loans.

Like Karofsky and Korn, Miller recommends showing the family members a comprehensive business plan to receive and repay loans -- "much as you would with a formal lender," he says. "That gives them more confidence in your abilities to start a business."

This could include a repayment schedule, or a promissory note for what would happen if things don't work out.