Medium-sized companies are increasingly turning to friends and family for investment, a trend once thought to be the domain of startups and businesses unable to secure bank loans. This shift highlights a growing preference for closer-to-home financing, despite the potential risks to personal relationships.
For many entrepreneurs, loans from friends are seen as the least expensive and time-consuming way to raise capital. Unlike banks, friends and family typically don’t demand high interest rates or detailed business plans. They’re also more likely to be swayed by personal enthusiasm rather than strict financial scrutiny.
The Risks of Mixing Business with Personal Relationships
While borrowing from friends and family may seem appealing, it comes with significant risks. Strained or ruined relationships are a common outcome if the business fails or if there are disputes over repayments. Alysoun Stewart of Grant Thornton notes that such funding is often a “lender of last convenience” during a company’s early stages, when revenue streams are uncertain.
A 2024 report from Starling Bank found that 20% of surveyed businesses relied on funding from friends and family. However, this approach requires careful management. Clare Grayston, a corporate finance lawyer, warns that it must be a “very grown-up process” to avoid complications.
Protecting Both Parties with Formal Agreements
To handle this delicate balance, experts stress the importance of formalizing agreements. Whether it’s a loan or equity investment, everything should be in writing. This includes clarifying terms like interest rates, repayment schedules, and the potential for shares to become worthless if the business fails.
For instance, if a friend offers a no-interest loan, setting up the agreement to include the current market interest rate can protect both parties. This ensures clarity and professionalism, reducing the risk of misunderstandings.
One potential issue is the lack of business expertise among friends and family. While their support is valuable, they may interfere in business operations or lack the contacts and knowledge of professional investors. Grayston illustrates this with the example of a sibling investor who becomes overly involved, creating tension.
Despite these challenges, companies like Timestrip have successfully leveraged friends-and-family funding. Joint-CEO Paul Freedman explains that they raised money from acquaintances, ensuring professional agreements and setting clear expectations about the risks involved.
Legal and Tax Considerations in Friends-and-Family Funding
When accepting loans from friends or family, it’s key to clarify whether the funds are a loan, gift, or equity investment. This distinction affects tax implications and legal obligations. For instance, gifts above £3,000 may be subject to inheritance tax if the lender dies within seven years of making the loan.
If the funds are a loan, the lender must decide whether it’s interest-free. In the event of the lender’s death within seven years, the outstanding sum could become part of their estate. Borrowers may also claim tax relief on interest if the loan is used solely for business purposes. These details should be documented to avoid disputes and ensure compliance with tax laws.
Consulting an accountant or solicitor is essential to handle these complexities. Proper documentation not only prevents fallout but also ensures transparency, which is critical if the business seeks external investment later. Banks and larger investors will scrutinize financial records, and unclear agreements can complicate future funding rounds.
Managing Shareholder Agreements and Future Growth
When friends and family invest, a shareholders’ agreement is essential to outline principles, exit strategies, and long-term goals. This document should address future share issues and resolve potential disputes. It ensures clarity on expectations, such as expansion plans and timelines, protecting all parties involved.
Creating such agreements requires legal expertise. Proper documentation and clear parameters are essential to avoid fallouts or tax issues later down the line. Failure to follow professional standards when structuring and documenting deals with friends and family can come back to haunt you if your business is successful, with disputes over repayments and share stakes likely to surface.
One big downside to borrowing from friends and family is that they may lack the business experience, contacts and nous of professional investors. Or, worse still, they are unaware they lack expertise, thinking they know it all and want to interfere in how you run the business. “Imagine your sibling has been successful in business and raised a lot of money,” says Grayston. “He becomes an investor in your business and suddenly he’s a know-it-all, but you feel you can’t say anything because he’s your brother! “And what happens if you want to expand the firm, but he wants to exit?
All reasons why you really should put a shareholders’ agreement in place – it could be as little as one side of A4 but it will protect everyone.
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