Seek professional advice to understand the implications of choosing between a loan and an investment. This choice can impact asset protection, tax obligations, and family relationships.
The costs of starting a business can really add up.
You might need to think about registering business names or setting up a company – and that’s before you even start buying stock, renting premises, obtaining insurance or perhaps get set up to work from home. You also need to consider the costs of a website, branding and marketing to attract customers.
If you’re just starting out, borrowing from 'the Bank of Mum and Dad' could seem like a great option. You might have parents, family members or even friends who are happy to invest in your business idea or be a guarantor for your lease or a bank loan.
This is not always such a good idea. In many cases, parents or other guarantors don’t realise the kind of financial commitment they are making by lending money to someone starting a new business.
Here are some questions to ask before getting your loved ones involved in the financial side of your business.
How will the money be treated?
If you do borrow money from family or friends, it’s important that everybody involved understands if the money is considered:
- a gift that you don’t need to pay back
- a loan to be paid back with interest
- an interest-free loan
- as purchasing an ownership stake (equity) in the business, meaning they will become part owners that share in profits and losses and have a day in the running of the business.
Tip
Documenting a family loan arrangement
While borrowing money from family or friends may feel like a more casual arrangement, we recommend taking a professional approach by having a formal agreement in place. This can ensure both parties have a clear understanding of how the loan will be managed. Your agreement should include:
- A clear repayment schedule detailing the frequency and amount to be paid.
- If interest will be payable on the loan (and at what rate).
- Documenting any additional loan terms.
- Confirming the relationship between the business owner and the family member or friend loaning you money. Will they be treated as a creditor (that has no ownership or say in the operation of the business) or will they become an investor in the business that has ownership (equity) in the business?
Can your loved ones afford it?
Acting as guarantor for your business loan isn’t just a show of your family’s moral support: it’s a financial commitment.
They will be held responsible for any debt repayments you can’t make, which might include your lease or bank loan. In the worst cases, parents can lose their family home if their kids are not able to make repayments or incur a debt.
If you do need your parents to act as guarantor, try to limit their liability to an amount they could reasonably afford. For example, if you need them to guarantee your lease, you might negotiate with your landlord to limit their liability to a smaller amount such as $10,000. Just make sure this is written into the lease.
Have you conducted due diligence?
If you’re buying a business and asking others to invest in your decision, it’s important to complete a risk assessment and compliance check – a process known as due diligence.
Are you prepared for a “no” if they can’t help out?
Our advisers spoke with a mother who had been asked by her daughter to guarantee a lease for a chiropractic clinic. Her daughter had just graduated from university and didn’t have a client base. She was prepared to lease premises to run her own clinic for an annual rent of more than $50,000. The lease was for a period of five years with a yearly rent review. This equated to at least $250,000 over the entire rental period.
The parents were prepared to invest in their daughter’s future and initially thought they would be doing the right thing by supporting her. They hadn’t considered how their daughter was going to make the rental payments and associated leasing expenses from day one of her business.
Starting with no client base, she would need to make a minimum of $1,500 each week just to meet her expenses. Without any savings to draw from, it was apparent to the mother that her daughter was going to soon fall behind in her rent and she would be responsible for covering the entire lease costs, of over $250,000. The parent made the wise but difficult decision to say no.
Have you considered other options?
It’s worth exploring a number of different options to fund your business. You could look carefully into a small business loan but it’s important to understand exactly what you’re signing up for. Another option might be to start small, launching your business on the side while you’re working part-time or full-time in another role. That way, you have a dependable salary until your business is stable. Most government business assistance is in the form of free or low-cost services such as those offered by us, so don’t rely on getting a grant although you might be eligible if your business meets the criteria.
If your family are keen to play a part in your business, you can get them involved in ways that won’t cost them anything. For example, you could invite their feedback on your logo or website design, or draw on any skills they have that relate to an aspect of running a business.
Please remember, the tips and details provided here in our blog are intended for general information only. If you would like advice about your specific situation, contact our free business advisory service. We also offer a free Starting a Business workshop and a range of other services to help you through the purchase or launch of your business and beyond.
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