Borrowing from Friends and Family

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Borrowing money from friends and family

– One of the first ways people usually consider to raise money is to turn to their friends and family to lend them the capital they need to start their company. It often sounds like a great idea, because those people are easily accessible and want to see you happy and successful. But the nature of the relationship itself, and the fact that those people are so close to you, is actually what makes it the most dangerous ways to raise money. When you raise funds through professional investors, everyone knows what the stakes are, what the potential upside is and, of course,the hard reality that 80 percent of all startups fail eventually, and that there is a very real risk of losing your entire capital.

With friends and family, it is actually quite different.Their motivation to invest in your business is actually related to the fact that they want you to succeed or to send you the message that they believe in you and want to support you in your entrepreneurial efforts.They might even be reluctant to give you their opinion, if it’s negative, so as not to demotivate you or have you thinking that they’re not supporting you.Usually, it even goes one step further, which is that friends and family can be reluctant to do any paperwork to formalize your agreement.

When you’re in that first phase, where everything is still possible, everyone is very happy. You’re getting the money, and your friends and family are happy to help you, but usually things get complicated further down the road. The question is, what happens if your company meets difficulties, and you’re not able to repay the loan? Is that going to be an issue? If your company files for bankruptcy, do you expect to repay the loan anyway? Those are all questions that need to be answered upfront.

When you’re dealing with an institution, all of those things are set in stone as soon as you sign the contract. You know who is responsible for the loan,what will happen if you miss a payment, and the full consequences of not being able to repay the loan.With friends and family, you need to have the same level of rigor in the borrowing process and define all those things. The benefit of doing so is that if things do turn sour, then there is no relationship or family issues added on top, since it will all have been defined in advance.

For example, if you’re having temporary difficulties,you need to define how you will handle it. Will you stop the monthly payment for a time, until your finances are better? Is your lender okay with that, and does he have the financial stability required to live without that money? If your company files for bankruptcy, will you be repaying the loan or not, and if so, will it be okay for your lender to wait until you have a new source of income to repay the loan? Will they accept a smaller monthly payment over a longer period of time? And even if you do, remember that those people are your friends and family, and they might, therefore, have an opinion on how you use your money.

For example, they could be okay to reduce your monthly burden and take it on themselves to let you repay the loan over a longer period of time, but they might also feel bad if they see you going out or on vacation, instead of paying them in an accelerated way. You, of course, might feel like this is a well-deserved night out or vacation, but chances are they will see it in a very different light. They might feel like they are financing your vacation. Those are things you need to take into consideration when borrowing money from friends and family.

Getting the money is usually the easy part, but the consequences down the road can be terrible. So, what’s the best way to borrow money from friends and family? First, you need to treat them like strangers, as far as paperwork is concerned. Don’t fall into the trap of believing that oral agreements are sufficient, just because you know each other. Then, protect their interests better than they will. As I said earlier, they will not want to protect their own interests, so as not to lead you to believe they mistrust you.

So, you have to do the job and insist on putting everything on paper. Go over every possible outcome, and then put in writing the way you will manage it. It is so important that I will say it again. Put everything in writing. Don’t rely on your memory or theirs to know what was originally said. And by the way, even if we all had good memories, we also all have different interpretations of what we say. Putting things in writing helps a lot in clarifying the agreement.

Even if that document might not have a legal value, it will be a great way to preserve your relationships.Borrowing money from friends and family is a dangerous game. If you must do it to get started, or if there’s no other way to get your company on its way,then do it, but put it all in writing and defend the interests of your friends and family as your own.

Securing investor debt

– In this video, we will be covering two types of investor debt, straight debt and convertible debt.Straight debt is the basic loan that you and I are used to getting for our personal needs. The money you borrow is to be repaid over a certain period of time.Or at the end of the period with a certain level of interest rate. That’s a great way to get capital easily. If your company has a certain level of revenue and is looking for capital in order to launch a new product or start operations in a different state or country.

For startups, this type of loan is usually accessible only if you’re personally responsible for the loan and repay it even if your company fails. Otherwise, banks are usually reluctant to lend money to startups given the high level of risk. Banks tend to prefer safer investments with a very, very low probability of default. For startups, the best way to get a straight loan is to borrow from friends and family.

But we’ve already covered this point previously.Convertible debt is different from straight debt only in the fact that there’s an added element in the contract that states that the lender can either receive his money back with interest or the equivalent amount in shares of your company at a certain point in time. Very concretely, you get the money, you pay nothing every month and at the end of the loan period, let’s say three years or five years, you either pay back the total amount due, interest included, or give shares for the total value equal to the amount due.

It is normally expected that the lender will convert the debt into shares when the time comes. This debt is then actually halfway between a debt and a sale of equity. The way it works is that the loan usually runsuntil you get to the next round of investment or to a significant milestone. And at that time, the person that lends you the money can get shares for an amount equivalent to the money that was given to you.

Plus a discount to compensate the lender for the risk he has taken. So for example, if you sign a convertible loan for $100,000 you could have a seven percent interest rate with that loan so that if the lender needs to get his money back then that could be the terms on which you will pay that back to him. If on the contrary, the debt is converted into equity then he will be getting shares of your company worth $100,000 plus the discount that was negotiated at the beginning.

In this example, let’s say 15%, you have to remember though that for a convertible debt to work you have to be able to get to another round of funding or to the major milestone you agreed upon. If your company does not meet that milestone then technically the lender could ask you to pay back the loan and force you into bankruptcy if you’re not able to pay back. So why would you be interested in using convertible debt? First, because it’s much simpler to get than regular investment money.

For regular rounds of funding, you need to value your company in order to define how many sharesinvestors will get for their money. In the case of convertible debt this discussion is postponed to a later time when you know better. The second reason which is tied to the first one is that because you will postpone the valuation discussion you will usually strike a better deal and give away less shares. When you are starting your company it is super hard to determine the value of your company.

And when you give shares in exchange for money so early on, you are never sure if you’re getting a great deal. At that time, you will always feel like you’re getting a great deal because you so much need that money to get started. But down the road, when you’ll see how your company was successful and you’ll have all the elements needed to value your company correctly, then you’ll have final answer as to if it was a good deal or not. For example, your company could be way more successful than you anticipated and in that case, great chances are that you’ll have given away more shares than you should have.

So convertible debt gets you the money all the samebut you get to value your company when you know better. Which is great.

 

Securing investor debt

– In this video, we will be covering two types of investor debt, straight debt and convertible debt.Straight debt is the basic loan that you and I are used to getting for our personal needs. The money you borrow is to be repaid over a certain period of time.Or at the end of the period with a certain level of interest rate. That’s a great way to get capital easily. If your company has a certain level of revenue and is looking for capital in order to launch a new product or start operations in a different state or country.

For startups, this type of loan is usually accessible only if you’re personally responsible for the loan and repay it even if your company fails. Otherwise, banks are usually reluctant to lend money to startups given the high level of risk. Banks tend to prefer safer investments with a very, very low probability of default. For startups, the best way to get a straight loan is to borrow from friends and family.

But we’ve already covered this point previously.Convertible debt is different from straight debt only in the fact that there’s an added element in the contract that states that the lender can either receive his money back with interest or the equivalent amount in shares of your company at a certain point in time. Very concretely, you get the money, you pay nothing every month and at the end of the loan period, let’s say three years or five years, you either pay back the total amount due, interest included, or give shares for the total value equal to the amount due.

It is normally expected that the lender will convert the debt into shares when the time comes. This debt is then actually halfway between a debt and a sale of equity. The way it works is that the loan usually runsuntil you get to the next round of investment or to a significant milestone. And at that time, the person that lends you the money can get shares for an amount equivalent to the money that was given to you.

Plus a discount to compensate the lender for the risk he has taken. So for example, if you sign a convertible loan for $100,000 you could have a seven percent interest rate with that loan so that if the lender needs to get his money back then that could be the terms on which you will pay that back to him. If on the contrary, the debt is converted into equity then he will be getting shares of your company worth $100,000 plus the discount that was negotiated at the beginning.

In this example, let’s say 15%, you have to remember though that for a convertible debt to work you have to be able to get to another round of funding or to the major milestone you agreed upon. If your company does not meet that milestone then technically the lender could ask you to pay back the loan and force you into bankruptcy if you’re not able to pay back. So why would you be interested in using convertible debt? First, because it’s much simpler to get than regular investment money.

For regular rounds of funding, you need to value your company in order to define how many sharesinvestors will get for their money. In the case of convertible debt this discussion is postponed to a later time when you know better. The second reason which is tied to the first one is that because you will postpone the valuation discussion you will usually strike a better deal and give away less shares. When you are starting your company it is super hard to determine the value of your company.

And when you give shares in exchange for money so early on, you are never sure if you’re getting a great deal. At that time, you will always feel like you’re getting a great deal because you so much need that money to get started. But down the road, when you’ll see how your company was successful and you’ll have all the elements needed to value your company correctly, then you’ll have final answer as to if it was a good deal or not. For example, your company could be way more successful than you anticipated and in that case, great chances are that you’ll have given away more shares than you should have.

So convertible debt gets you the money all the samebut you get to value your company when you know better. Which is great.

 

Getting loans from the Small Business Administration (SBA)

– The Small Business Administration is a government entity whose purpose is to help small businesses to grow and thrive. One of their activities is to help small businesses get loans. People usually refer to it as SBA loans but that’s not exactly how it works. The SBA does not lend money per se to small businesses. It rather provides guarantees to financial institutions so as to reduce their risk and facilitate small businesses’ access to loans.

The way it works is that if your company is eligible, the SBA will take responsibility for a large portion of your loan and if your company cannot pay it anymore the SBA will pay back the amount on which you took responsibility. In some cases, each responsibility can go up to 80 percent of the loan, which is very high.That means that when a bank evaluates a loan for a company that is eligible for SBA-backed loans then the risk the bank is taking is really on only 20 percent of the total amount.

In concrete terms, if you borrow 100,000 dollars from a bank, and the SBA guarantees 80 percent of it, that means the bank will be able to get back up to 80,000 dollars from the SBA, if you default, and its risk is therefore on only 20,000 dollars out of the total loan.In essence, for the bank, then it is as if they were considering giving you a much smaller loan and it becomes, therefore, much easier for your company to get it.

Of course, since the SBA is a governmental entity and is putting taxpayer money at risk, it is requiring a lot of information before it decides to back your loan. It can therefore be administratively intensive for an entrepreneur. Some of the requirements to be eligible are to be working for profit, to have looked for other sources of money before turning to the SBA, includingusing your own personal money for at least 10 percent of the amount you are requesting, to present a business plan and financial projection in order to articulate why you need the capital, to have no debt obligation towards the US government, and for them to be able to take back the equipment you bought with the loan if necessary to recover as much money as possible if you default.

There are other requirements, and you can find all the details on the SBA website at SBA.gov. Those, I think, are all very valid requirements necessary to ensure that the taxpayer money is well-managed. The second area the SBA is active on in relation with our topic here is the SBIC, or the Small Business Investment Corporations. The SBICs are private organizations that are regulated by the SBA.

They invest in businesses and usually focus on specialized areas. For example, on companies that have a socially or economically disadvantaged ownership. To know more about SBA loans, the best next step is to go to the SBA.gov website, which is very well-designed. You will find information on things like the 7(a) programs or the 504 programs and the SBIC programs. Those are the programs we have just described, and since they change regularly that’s the best way to get fresh information.

 

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