"The richer your friends, the more they will cost you." — Elisabeth Marbury.
After considering their personal resources, the next place most entrepreneurs look for additional financing is to "insiders" like family, friends, or business associates. Borrowing from insiders is attractive because it's private, often informal, usually unsecured, and often includes favorable terms, and because legal default proceedings are seldom invoked. In addition, this kind of financing can often be incorporated into a family's estate plan to assist in minimizing estate and income tax liabilities.
However, financing from family and friends is often a double-edged sword. Counterbalancing the convenience and low cost of insider financing are the misunderstandings, personal conflicts, and other problems that can arise from a lack of business formality or economic success. These dangers can seriously damage both the business and the long-term personal relationship between the parties. If you do seek financing from insiders, keep in mind the following suggestions and cautionary notes.
Insider debt financing: gifts vs. loans. If a friend or relative is contributing capital as a gift, you should embody that understanding in a written "statement of gift." Note that the gift may have tax consequences. The federal Internal Revenue Code allows an individual an annual exemption from gift tax in the amount of $11,000 per recipient. For example, if your parents wanted to give you a tax-free gift, they could each give you $11,000 per year (total gift of $22,000 annually). Gifts in excess of this amount would count against your parents' lifetime estate tax credit and might require the filing of a gift tax return.
If the transfer of funds is not intended to be a gift, an enforceable agreement such as a promissory note should be drafted that reflects the nature and terms of the exchange. The temptation to forego arm's-length formalities must be avoided. For instance, the absence of interest charges, or below-market rates, may be a red flag for the IRS to question whether the transaction is really a gift, rather than a loan. If the IRS accepts your treatment as a loan, but finds that little or no interest is being charged, it may "impute" interest and tax the lender on the interest that he or she "should" have received.
If the insider does not want to participate in control or ownership of the business, a promissory note stating that the money is a loan, and listing the terms of the loan, should be drafted.
Equity financing by insiders. If you want the insider to become an owner of your business in exchange for financing, documentation of the arrangement is again important, but the paperwork will vary according to the type of ownership interest you are transferring.
For example, if the business is incorporated, a sale of stock ownership can be relatively simple. Attention should be given to ensuring that the value of the capital contribution fairly represents the value of the ownership and control interest being sold; otherwise gift tax and director liability issues may arise. In addition, the issues discussed in equity financing concerning business control and ownership issues (e.g., rights of shareholders, elections of directors, cumulative voting, preferential rights, minority oppression, stock transfer restrictions, and buyout arrangements etc.) may need to be readdressed in the corporation's by-laws.
If the business is not incorporated, equity financing should include a
drafting or redrafting of the partnership, limited partnership, limited
liability operating agreement, or joint venture arrangement. The rights,
liabilities, and responsibilities of the new participants should be defined
clearly to avoid later confusion, disagreements, or unanticipated liabilities.