Published June 2007

A Cash Infusion

By Fred S. Steingold (page 86)

Most small businesses will turn to family, friends or the local banker for working capital; be sure to know your options before moving forward.

Looking for money to help grow your business? The cash may be closer than you think.

When brothers David and Donald needed money to expand their portable restroom business, their parents gave them a gift of $18,000.

• When Joe needed money to put toward a new vacuum truck, Aunt Carol loaned him $12,500 to be repaid in monthly installments over a four-year period.

• When Lou needed money to open a second location for his pumping business, he incorporated and sold $30,000 worth of stock to Ted and Alice, longtime friends since high school.

Many businesses turn to family and friends for cash infusions. In the startup days, the founders of many famous companies — from Wal-Mart to Motown Records — relied on money from family members and other people they knew well. Millions of other business owners tell a similar history.

Small businesses often don’t qualify for bank financing. Similarly, they’re unlikely to get money from a venture capitalist. Those avenues are often closed to smaller companies. And even if you do qualify for a bank loan, you’ll have more flexibility in dealing with family members and friends.

Let’s look more closely at each of the three money sources illustrated in the above examples: gifts, loans, and equity investments.

Gifts

A gift is a possibility if you have wealthy and generous parents or grandparents. Currently, a person can give $12,000 a year to any number of people without raising tax concerns. So, for example, Dad can give you $12,000 and Mom can give you $12,000. And they can give similar amounts to each of your brothers and sisters. The $12,000 limit may be increased in the future, depending on how quickly inflation rises.

Gifts that exceed the $12,000 annual limit are OK, but will reduce the donor’s federal estate tax exemption. That exemption is set at $2 million until 2009, when it goes up to $3.5 million. Before making a big gift, a donor should talk to a tax advisor. Chances are, however, even a very large gift won’t affect most donors’ tax liability. As the recipient, you have no tax worries about gifts — no matter how large.

While gifts are wonderful, in most cases you’ll be looking at the other two ways to get money. Each offers advantages and disadvantages.

Loans

With a loan, of course, you make a commitment to repay the money you borrow. Loans offer several advantages over raising money through an equity investment. For one thing, you maintain complete control of your business; the lender can’t dictate management decisions, and has no claim on business profits. If your business prospers, the profits are yours to keep.

Another advantage of loans is that the interest you pay is a tax-deductible business expense. And — especially when borrowing from family and friends — the interest rate and repayment terms can be flexible.

But loans do have some disadvantages. Loan repayments can put a strain on your business budget. And you may have to give the lender a security interest — like a second mortgage on your home. This clearly puts your home and other personal assets in jeopardy. Whether or not you give a security interest, the lender can usually sue you if you don’t repay as promised.

Granted, a friend or relative is unlikely to sue you. A bigger problem is that if you don’t repay the loan, you can put a strain on your relationship with the lender. So be doubly sure that you can meet your repayment commitment. To keep the matter businesslike, sign a promissory note. This leaves no doubt about how much interest you’ve agreed to pay, or the frequency and amount of your repayments.

Equity Capital

The main alternative to a loan is to have a friend or family member invest in your company. The investor becomes a “shareholder” if your business is a corporation, or a “member” if your business is a limited liability company (LLC).

On the plus side, your business usually isn’t required to repay the money that’s invested. Instead, the investor agrees to accept dividends or other distributions if the business is profitable. You can also agree that the investor will have a preferred position if you sell or liquidate the business, so that the investor gets paid before you do.

The investor can be part of your management team. With a capable investor, this can be a source of wise guidance.

The downside, of course, is that you won’t be entitled to all of the profits. You’ll have to share with the investor. And the investor may assume a more active role in running the business than you’d like. However, you can usually work out the terms of the investor’s involvement through a written shareholders’ agreement or LLC operating agreement.

Just as with borrowing money from a friend or relative, you need to carefully document the role of the investor. This will require more paperwork than if you raised the same money through a loan.

More Information

If you’d like to learn more, I recommend the book, Investors in Your Backyard: How to Raise Business Capital from the People You Know, by Asheesh Advani ($16.49, Amazon.com).