The possibility of availing finance from family and friends to start or expand your business venture is attractive, no doubt, but comes with several riders. We take a look at its pros and cons.

If you have ever approached a bank for a loan, or done rounds of angel investors seeking finance, you probably know how difficult it can be to get a loan or investment. The process of ‘asking' for finance involves a whole lot of work, as a potential financier will want to review your capacity to repay, the capital you've personally invested in your business (this is sign of your confidence in the venture), the collateral or additional security you intend to offer to back up repayment, the purpose or business plan the finance will be used for, the prevailing economic climate that could favourably or otherwise affect your business, your expertise in your chosen field of business, and last but certainly not the least, your character and professionalism.

Family finance - not a last option

As far as your character is concerned, a potential funding agency will most be interested in your trust- and credit-worthiness. Sometimes, if you're just starting out a new venture and don't have a substantial business track record, it can be hard to convince an outsider of your bona fide intentions. In such instances, turning to family and friends, where you may have ‘readymade goodwill' based on many years of positive vibes, could be a way out.

Personal Finance Advisor T Ravi points out that "there is no point in blindly shutting out a source like family finance when you're in need. Only, like in every other situation in life, keep in mind that this too has its advantage as well as disadvantage."

In fact, to many, family finance presents as an easier option vis-à-vis approaching a bank or financial institution. Why? In nine cases out of ten, family and friends will want to help you. Say you have a well-to-do, well meaning uncle who has ten lakhs stashed in a bank and is convinced you can apply these funds to better and more remunerative use - certainly, he is likely to be more than willing to offer you use of this money.

For these reasons, family finance is often available at more flexible terms - this could imply lower or no interest rates, no or less security, or a longer or deferred repayment schedule.

It shouldn't be a walkover

However, the catch is in convincing your family and friends of your proposed ‘more remunerative' use. You may think, ‘My uncle or father would willingly give me the money, I don't really need to convince him of the soundness of my business plan,' but in truth, you must.

Chartered accountant, businessman and tutor in business studies Vijay Ladha opines that although he considers family finance a very important and good medium of business financing, this holds true only if like all business decisions, these decisions can be taken without letting sentiments, emotions and personal biases get in the way, and are instead based on logical business reasons and requirements.

This implies that although family finance may be easier to obtain, that process shouldn't turn into a walkover - by you simply asking for 10 grand and receiving a cheque in return. In other words, the possibility of your potential family financier saying ‘No' should enter your scheme of things. Proceeding with this reality in mind is actually quite useful as by necessitating a sound business plan, it will ensure you think things through, and don't start on some half-baked business idea - all the more if an alternate source of funds has turned you down.

It may come from family, but it isn't free

Along with other business viability and risk factors, you should also take into account the cost of the funds you are borrowing from your family. After all, no funding is free, as it always has an alternate use associated with it which determines its market rate of interest. Ladha points out that although a father may not seek interest from his son for money advanced for business, a prudent son should ensure that he accounts for the notional interest on the contribution to determine his business viability and to ensure that his business accounting is a fair and true assessment of its operations.

Speaking of his interaction with graduate and post-graduate business students, Ladha shares how many of them simply presume that their fathers will finance their business, as though they have a right on their fathers' money. "Their train of thought is - ‘My father is rich, he would not let me take a loan, how can I ask a bank for a loan, after his death the money is mine anyway, and so on and so forth,'" he says while emphasizing that the difference between requiring money for personal or business reasons must be appreciated.

"A parent or family elder may retain the option to loan money for business, and accept repayment with or without interest; and in future, gift the funds to the borrower based on their personal relation. At least that would have proven the borrowers business acumen and business operations. I strongly believe that using family funds to startup a business, and then returning these with reasonable returns strengthens personal relationships. Businesses run on family funding with unclear understanding run into rough weather when they make too much profit or lose too much money. In either case, there are problems and hence the ownership of the operations should lie with individual and his personal capabilities," he continues.

The need for a written agreement

In saying this, Ladha brings up an interesting point. You'd think that taking funds without intending to return them could be tricky - from the perspective of potentially damaging family relations in the long term if the investor asks for his money back when he needs it, and you're then not in a position to comfortably part with the money. But consider a scenario where your business is making a healthy profit and your investor demands his share or worse, desires to get involved in its running. Wouldn't you feel uncomfortable?

Ravi practically points out how extended family members are often "keen on keeping a watch to see if ‘uncle's' family seems to be spending more than their own; without considering any past contribution or struggle this ‘uncle' must have made or gone through. Fact is - while siblings can quarrel and patch up quite easily, family involvement spells a different ball game altogether. Even where siblings are concerned, Ladha believes a person taking family funding for a business should also consider the possibility of a younger sibling needing similar family funding a few years down the line.

For this reason, family financing must be associated with a clear written agreement witnessed by an independent person, irrespective of whether your financier has offered you a loan or invested in your business as capital.

Loan or investment - what will it be?

In case of a loan, the agreement will mention its size, duration, a detailed repayment schedule specifying dates and amounts, and interest rate applicable. In the case of capital investment, it must state the amount invested, the role and responsibilities or liabilities of the investor, dividend or profit payouts and a repayment schedule. You must also specify how any problems arising will be resolved. Alongside a repayment period, Ravi also emphasizes the need for a contingency plan in case you're unable to keep up this commitment.

At the end of the day, the kind of finance you receive may or mayn't be your choice, as it will reflect your and your financiers' expectations, and tax and other obligations. Invariably, it is prudent to share all the risks inherent in your venture, and only accept funds that are less than an investor can afford to lose. You may jointly decide that a loan will work best - especially if you need immediate and relatively short-term funds. If your financier invests in the venture as capital, determine whether s/he will be an active or passive shareholder.

Usually, you retain control of any business where you hold at least 70 percent shares. According to Ladha, family finance should ideally be in the form of loans and not capital participation, as a loan can have a predetermined rate of return and leave the entrepreneur free to take his business calls.

Irrespective of the kind of finance you agree on, keep records of all repayments of the principal sum and interest or dividends. Keeping track of your ‘business' family relation will go a long way in creating a win-win situation for you and for your investor. 

Charu Bahri is a freelance writer and author of two books. She also writes funding grants and software for a charity working in the health sector.

Issue BG81 Dec 07

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