ABA Family Legal Guide

Forming and Operating a Small Business

Starting a Business

Financing a Business

What do I need to consider if I want to get a loan from family and friends?

The next best thing to using your own money (either directly or as collateral for a loan) may be a loan from family and friends. The pluses are that you won't have to go through a lengthy application process, repayment terms could be more liberal than you'd get from a bank, and rates could be lower, maybe even nonexistent. The minuses are that you'll strain your relationship with family and friends if the business fails.

If you do get a loan from this source, it probably will be at least as much because of personal relationships as because of the potential of your business. But that doesn't mean that it should be just a handshake deal. It's almost always best to put the terms in writing by signing a promissory note. Loans that go sour are probably right up there with martini abuse as a source of family eruptions. At least with the agreement in writing, you won't have two (or more!) widely different memories of who promised when and what. And if you are unable to repay, Aunt Carol is in a far better position with a promissory note to convince tax authorities that her loan to you should be a tax write-off and not a gift. (She might be in an even better position to get a tax write-off in case of loss if she had an ownership interest, either as a partner or a stockholder; see page 492, "Types of Business Organizations.")

A promissory note is a legally binding document in which you set out the terms of the loan: how much you got, the interest rate, how long you have to repay, the rate of repayment. You can get forms for promissory notes in stationery stores; some personal finance computer programs have them, too. The forms are just the template--you add the terms for your particular agreement by filling in the blanks.