Why borrowing from friends can end up costing you dearly

Sourcing the business financing to launch or grow a small business has always been tricky. Research suggests finance is an issue for at least 200,000 Australian small businesses at any given time, and just under a third of all small business owners believe they have missed an opportunity to grow due to a lack of credit.

Yet if a small business loan from a bank isn’t on the table, options can be limited. You may be able to borrow against an asset such as the family home or max out your credit cards but chances are at some point you’re going to contemplate asking a relative or mate for money. Here are some issues you should consider:

Blurred boundaries

Even in a best-case scenario, where no major disputes arise, turning a loved one into your banker changes the relationship.

For starters, you’ll probably need to share lots of private information about your financial situation. Next, you’ll have to accept that someone who has provided you with an unsecured business loan will take more than a friendly interest in your budgeting. A financial institution won’t care if you buy a new car as long as you’re meeting your obligations. But that old school mate who’s bankrolling your startup may feel entitled to police your spending habits. And catching up with your best friend may no longer be as enjoyable once the main topic of conversation is how your business is going and when they’ll get their money back.

The potential for misunderstandings

In a perfect world, small business owners and the friend or family member providing them with money would always sign a contract. It would state whether the money in question was a gift, loan or investment. Assuming it was a loan, the contract would then detail how much, if any, interest was to be paid and when repayments were due. In the real world, precisely because of the pre-existing personal relationship, such a contract often never materialises.

This means costly misconceptions can easily arise. Even if it’s described as a loan, both parties might initially treat it more as a gift, with a vague understanding that the money will only need to be repaid when the business reaches a certain level of profitability. That’s fine, until the lender decides it was a loan after all. And that they want their money back, in full and immediately.

Even more risky, is that the lender may come to see the small business loan as an investment. If the business turns out to be the next Facebook, they may come to believe they’ve purchased an equity stake in it. Alternatively, they may be on the hook with the business’s creditors if it goes bust.

A lack of tough love

The failure rate for small businesses is notoriously bad. Perhaps the most common cause for those failures is a lack of homework. Unlike your footy buddy, a professional lender will ask you to provide detailed evidence that your actual or proposed business is viable. As tedious as that process can be, it frequently results in small business owners coming up with better business plans and making wiser financial decisions.

A smart alternative to the Bank of Mum and Dad

So you’re unable or unwilling to get a small business loan from a traditional lender, and don’t want to impose on your nearest and dearest. What now? Like many other industries, the financing game is being transformed by new entrants offering innovative products and services. Prospa, for example, has become Australia’s leading online small business lender only four years after launching. We focus on the health of a business when making lending decisions and can approve loans of up to $300,000, often within 24 hours.