Posted by Shivali Anand
August 4, 2021 | 3-minute read (584 words)
Starting a new business comes with a slew of challenges. First among them is you must earn a profit to keep yourself and your company afloat.
Any new business will require cash inflow, which poses a common dilemma: Will you raise capital from family and friends, or will you seek money from a third party, such as a venture capital firm?
If you’re contemplating borrowing from family and friends to operate your business, be sure to weigh the benefits and drawbacks, which we will describe here.
Low-Interest rates and “easy” money
The money you borrow from family, friends and peers is usually simple to get and carries little or no interest. The terms, on the other hand, may vary with the individual. Is it a gift, or is it a loan? If it's the latter, you must work out whether it represents an equity investment in your business. These considerations must be addressed from the very beginning to avoid misunderstandings and anger later on. Create a contract that lays out all of the terms and conditions so that everyone is on the same page before signing on the dotted line.
Making a financial statement
Money borrowed from friends and family is unlikely to assist your firm in developing a credit history or financial track record, both of which are critical for a growing business. You will be expected to share your growth and expenditure statistics with financial institutions at some point to win their confidence and obtain capital infusions if required. In certain circumstances, this may require your business to have a high credit rating, which you are unlikely to have when borrowing from friends and family.
The majority of business finance or capital comes with various advantages and privileges exclusive to that particular product. Money from a venture capitalist, for example, might open doors to networking possibilities you wouldn’t have otherwise. These types of advantages are only available when you use traditional lending methods rather than borrowing money from friends and relatives.
Relationship with a traditional institution
If you receive a loan from a financial institution, you'll be improving your company's credit rating. The fact that you've maintained a solid relationship with your bank and had a long history with them will make you more appealing to the bank.
Understand the risks involved
Whenever you borrow money from friends or family, you’re taking a risk. They may lose their funds and receive nothing in return. Be sure to provide your investors with a solid business plan that outlines all potential risks, as well as a legal document that you can refer to if necessary. It is possible to win or lose money. When money is involved, though, relationships can be strained.
Consider the position of a traditional financial organization in the same scenario. They will start the decision whether to lend you money by first examining the company's advantages and disadvantages. If they sense any risk and still move forward, it implies they are prepared to take a chance with their money and would not be as upset at losing it as friends or family members would be. Your credit may suffer, but that's not the same as putting a burden on a relationship with a close family member or friend.
Takeaway: These are some of the pros and cons of getting money from sources other than banks. Whatever path you take, make sure you read the funding source's terms and conditions and that everything is in writing.