The situation is deceptively simple -- a would-be small-business owner has difficulty finding enough money to start his company. Perhaps he has bad credit and the bank denies him a loan. Perhaps he's inexperienced at running a business and unsure where to turn for funds. So, he calls up his father, mother, or a close friend and asks for their support. What could go wrong?
More than he knows. Borrowing money from family members is a complicated process fraught with tension, and business owners who choose to do so must consider the possible repercussions.
PREPARE FOR PROBLEMS.
Family business advisor Paul Karofsky, who formerly contributed a column to BusinessWeek Online, says borrowing from one's family is very different from a straight business relationship. "It's risky business to borrow from family members," Karofsky says. "It needs to be a last resort, not a first resort. Family members need to know you've exhausted all other possibilities."
With families, Karofsky says, "We value people for who they are." In the business world, it's about "what people do and how well they do it. The incompatibility of these systems can create enormous stress."
Al Korn, the chairman of the Small Business Administration's (SBA) Counselors to America's Small Business program (SCORE), agrees that there are many risks involved in failing to repay family members on time. "A banker will send you a nasty letter," he says. "A relative will remind you [about the money] every time they see you."
Karofsky stresses that there must be clarity about whether the money involved is a loan or a gift, and that a written agreement of some kind should always accompany any money lending. If a family member makes a loan, he says, it should be clear what kind of interest it carries.
Personal issues become tricky, he says. How often is it O.K. to talk about the loan at family gatherings? "There need to be some boundaries," Karofsky says. "Is this something you talk about on Saturday night when you're at dinner together? This is a real, legitimate business transaction."
People who do choose to borrow money from family members -- after considering the unpleasant factors involved -- can still be successful. After all, when there are no other options for someone who wants to start a business or keep their business open, family members are always there.
"Of course it's not ideal," says John Miller, a spokesman for the SBA's New York District Office, "but if you don't have good credit, for example, you won't get a loan from anyone else." As a first resort, he says, a prospective business owner usually uses his or her own personal funds, and then credit cards. After that, people tend to go ask relatives and friends.
Josh Kalter, who worked for a large international trading company before he decided to start a metals business, is one success story. After consulting with SCORE counselor Max Wagner, he decided to both use his own money and have his father and brother-in-law help him out. They opened up certificates of deposit at the bank, which then extended lines of credit against the CDs. That way, Kalter says, "the money is guaranteed."
"If I were to default," he adds, "they would take money out" of the family's account. Kalter's startup, Network Metals, is now a successful small business in New York, importing metals and representing foreign metal producers in the U.S.
A report released by the SBA's Office of Advocacy showed that entrepreneurs starting a company alone believed they needed around $6,000 to launch it. The report also stated that 8% of these businessmen planned on seeking bank loans.
Like Karofsky and Korn, Miller recommends showing the family members a comprehensive business plan to receive and repay loans -- "much as you would with a formal lender," he says. "That gives them more confidence in your abilities to start a business."
This could include a repayment schedule, or a promissory note for what would happen if things don't work out.
Miller says an interest payment schedule is a good idea, and the owner should definitely make it clear what will happen "if all that money is lost."
Karofsky says guarantees could even include something like a second mortgage on the owner's house. But that could put relatives in an uncomfortable position. In effect, Karofsky says, the owner is saying to his or her relatives, "You would have a second mortgage on my house if this thing goes broke. If this thing goes, are you prepared to put me on the street?"
Overall, Karofsky says, "My basic guideline is [to] keep [lending] to an absolute minimum," especially since business obligations make relations so tense.
In New York City, which has thousands of small businesses, these issues can happen anywhere. And in a city flush with immigrants, the ethics of borrowing money from family members sometimes differs from group to group.
The SBA's SCORE program for small business owners sees 40 to 50 walk-ins a day, Miller says. "Counselors go over what are the sources of financing, including family loans. People typically aren't shy when they talk about what their finances are." Which is a good thing, "since 15% to 20% of family loans go belly up," Miller adds.
In Queens, the most ethnically diverse county in the U.S., immigrants hail from more than 130 countries -- but many immigrant business owners still shy away from borrowing money directly from their families.
Flushing, a neighborhood in western Queens, contains New York's largest Chinese population and an equally sizable Korean one. Fred Fu, the president of the Flushing Chinese Business Assn., says Chinese business owners in Flushing tend to start businesses using money from their savings. "Very few borrow money from their families," he says.
Chinese restaurants, Fu continues, "will have two, three, or four partners" that share ownership. He added that it's more common for friends to join together and form a business than for Chinese immigrants to seek help from their families.
Each immigrant community, of course, gets money from different sources, not always their friends or family. Fu says that Korean business owners in Flushing -- and all over New York -- often receive loans from their church, since churches play an enormous role in Korean communities. "It's like a circle" in the community, he says. "Koreans get money from the church and they give money back to the churches."
No matter where you live in New York City or from what country you hail, the chances of having a successful small business in New York are depressingly low.
Korn says 95% of all small businesses in New York fail. The SBA tries to help businesses get money if they can, he says. "If they have some marginal credit, we can get them some money. But if they're just completely unknowledgeable about what they're going to do, no bank is going to give them money. They have to have a business plan." And such a demonstration of professionalism can only help to sway dubious family members, too.