to be realistic with them.
Most businesses need financing along the way. They need it at the start-up phase, the growth phase and all the other phases that occur during the life of an enterprise. If your personal savings can cover every phase, good for you. (You can stop reading now.) For most of us, we need to have alternative financing methods in mind. We need to keep reading this book. And by learning the various financing methods we then have to ask: Should I use up all of my personal savings to get the business going? Should I consider the other alternatives so that not all of my savings are at risk?
We should also clarify what we mean by personal savings. They do not include money in retirement accounts. Your IRA and 401(k) are savings for your sunset years. They are usually protected from creditors and the bankruptcy courts. Pulling these monies out of a protected retirement account (which can incur large penalties and fees if done wrong) may be a very bad move. If your retirement age is nearing and you don’t have enough time to rebuild depleted accounts, it could be disastrous.
Beware of charlatans on the internet claiming you can easily use your retirement money to start a business. These firms tell you that by using a self-directed IRA or a special 401(k) you can easily use your retirement funds to invest in your own business. But what they don’t tell you is that the IRS has strict rules regarding such transactions. We will discuss these issues further in Chapter 6.
The bigger point here is that whether it is your personal savings or retirement savings, you may not want to go all in. You may want to use other proven strategies to finance your business or real estate investment.
Let’s consider the second most popular method.
Friends and Family
Friends and family have always been a great source for boot strap financing. Friends and family want you to succeed and are a lot more likely to take a chance on you than any bank would. That personal belief in you, that personal connection, is a special bond. Be very careful about testing it with a business transaction.
Your relationships are more important than your business. We start with that premise. Accordingly, many seasoned entrepreneurs advise others to never accept money from friends and family. Their take is that if your idea has merit you can find an angel investor and avoid testing a personal relationship altogether. Friends and family members have lost money in the past and will do so in the future. Do you want to be the one to have to confront it every Thanksgiving?
You have to ask yourself that same question. It is gut check time. This type of financing is often called the “family, friends and fools” approach. We don’t want you to be the fool for taking money from family and friends that may never be repaid—you may never hear the end of it.
Alright, now that you are sufficiently forewarned and prepared, let’s discuss how to do it the right way. A huge amount of money is raised from friends and family for investments every year and not every Thanksgiving dinner is being ruined. Obviously, some people are doing it right.
Here are four tips to consider.
Understand Their Motivation
A large percentage of friends and family members’ sole motivation is to help you out. They may not tell you this, and you can’t assume it, but they may even consider their money to be a gift. That said, they may also see their extension of money as a reasonable investment. They believe in you and your project, and if a decent return comes with it, all the better. Ask yourself why they are investing, and tailor your approach to meet their needs.
A key in this is knowing when to say “No.” Within your reservoir of goodwill are some people who will help you to their own detriment. If a friend or family member really can’t afford to help you, don’t even ask.
Be Honest and Transparent
Make sure they know the risks of the investment before you take their money. Explain that not only are you not likely to become the next Google but that they may actually lose their entire investment. Make sure that the money they are providing is money they can afford to lose.
While this may not sound like a very positive conversation to have when everyone is charged up to conquer the world, it is a necessary step. Your supporters will appreciate your candor, and may even continue to socialize with you if things don’t go well.
Consider Taking Money As A Loan
You don’t always have to sell equity in your company. It may be appropriate to borrow the money from friends and family. You promise to pay it back, with interest. And then you do so. Most businesses offer no liquidity, meaning it is very difficult to cash out an equity investment. So even if the business survives your friends’ money is stuck in the investment. By borrowing the money and paying it back, your supporters have helped you get started and you are square with them.
Interestingly enough, friends and family may be more pie in the sky about this investment than you are. They may have visions of $1,000 turning into $1,000,000. You have to be the adult. A loan may be the safer course for them and you need to tell them so. If they really want equity in the company they can buy in at a later round when things are hopefully more stable.
Get Everything in Writing
Be sure to put the terms of your agreement in writing. If it is a loan, a promissory note with an interest rate and payment time frames should be drafted. If it is an equity investment the terms must be spelled out with specificity. The assistance of an attorney is strongly suggested. Be sure that all parties agree to all the important terms and details and then sign and save the agreement.
Many people lament the end of the handshake deal. They ask why everything has to be in writing nowadays. And the answer is because our lives have become too over stimulated with computers, smartphones and television. We are constantly bombarded with new information, new things to process and new distractions. As a result, to expect two people to remember exactly the terms of a handshake deal that was agreed to even two months ago is almost quaint. Certainty is found in well-drafted written documents. This rule applies for all financing methods discussed from here on in.
There’s another reason why putting this agreement in writing is so important: the IRS. If your business doesn’t succeed, your lender may be able to deduct the losses from the loan. But if there is nothing in writing and no repayment schedule, fat chance that will happen. And it gets worse: the IRS may treat the money they lent or invested as a gift, which if the amount is large can create gift tax issues.
Next, we’ll talk about another popular method of business financing that will most certainly involve a contract.
Tapping Home Equity
Just a few years ago, home equity loans were one of the easiest ways to finance a business. Home values were high and lender requirements were lax. That changed dramatically when the housing boom turned to bust. With less equity and much more stringent underwriting by lenders it’s harder to turn your equity into start-up capital.
But these loans haven’t gone away entirely. Seventeen percent of businesses with less than $100,000 in sales use home equity lines of credit for business purposes, according to Barlow Research’s Small Office/Home Office Opportunity study.
There are several ways to use home equity to borrow for your business:
• A home equity loan or line of credit
• Refinance your current mortgage for more than you owe, and take cash out for your business
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