Recently, I have had a number of clients approach me about making loans to family and/or friends. Any book you read on entrepreneurship or funding an entrepreneurial venture advises that the would-be entrepreneur first approach his or her friends and family.
This advice struck me as off for several reasons. First, it presumes that your friends and family are not like you and have extra money to lend. Second, it ignores the strain money can have on your key and primary relationships. On the other hand, if you are the one in your family that every treats like a savings and loan, you know what I mean. I am sure I am not the only one who has lost a “friend” over money.
“Keep your family and business completely separated…”-Christopher Wallace
If you can avoid it, please try to avoid cosigning a loan for a family member or lending them money for their business, unless you would like to inject a new level of tension and awkwardness into the relationship. However, as often is the case, clients do not want me to tell them what not to do, but rather how I can “enable” them to do what they want while minimizing the risk of said action.
Assuming this is the case, I have come up with seven rules that will help you preserve your relationship and help your family and friends if you are approached for a loan or investment.
RULE NUMBER 1: Never lend what you are not willing to give.
Investing or loans are fraught with risk. You must be willling to accept that there is a very good chance you will never see your money again. In order to continue to sleep at night, do not lend or invest what you are not willing to give. Do not go into your 401(k). Do not take out a line of credit on your home.
If you do not have it to give, you do not have it to invest or lend. As I told one of my friends, “to give from a position of strength is a gift. To give from a position of weakness is a sacrifice.”
RULE NO. 2: NEVER GIVE THE AMOUNT REQUESTED (Set a ceiling)
This rule dovetails with Rule No. 1. Even if you have the funds, you need to limit your downside. For example, most banks rarely provide a borrower with 100% of the funds requested. For mortgages, it is typically 80% loan to value. The reason for this is because they want the borrower to have “skin in the game” as well. I advise that even if you have the funds requested, you set a limit so that you cap your risk and insist that the borrower or entrepreneur has some skin in the game.
RULE NO. 3: NO NEW LOANS UNTIL ANY OLD DEBTS ARE RETIRED
Family is especially adept at digging themselves into a hole they cannot dig themselves out of and because they believe that there will be no repercussions because “they are family.” Protect yourself and protect them from themselves. Explain that their “line of credit” is used up until they retire any outstanding loans.
RULE NO. 4: CHARGE A REASONABLE INTEREST RATE WHERE APPROPRIATE
I was explaining the time value of money to my ten-year-old son the other day. Basically, that a dollar today is worth more than a dollar tomorrow. Thus, you should always charge interest on your money, as it is the rental on not having the use of your funds. Just make sure that your rate is not predatory or usurious (READ: Check your state laws).
RULE NO. 5: COLLATERAL
Now, this seems extreme, but you should take collateral where you can. Not that you would need it, but that would definitely motivate the borrower to pay you back, posthaste. Items of either sentimental and/or monetary value are appropriate.
RULE NO. 6: RELATIONSHIPS OVER MONEY ALWAYS, BUT MONEY REVEALS THE NATURE OF THE RELATIONSHIP
In the movie the Bronx Tale, the narrator is upset because a guy in his neighborhood owes him $20, but keeps avoiding him. His mentor, Sonny explains to him that for $20, he got the guy out of his life forever. Looked at this way, he got off cheap. Stated another way, money doesn’t change you, it just makes you more of who you are.
If you want to see how strong your relationship is, inject money into the equation. It will reveal a person’s character quicker than anything. Just be prepared to have your feelings hurt.
RULE NO. 7: IF YOU PLAN TO BREAK ANY OF THESE RULES, YOU SHOULD PREPARE A WRITTEN AGREEMENT.
This is another one I picked up from my time working in the banking industry. Whenever you do a loan closing, it is a very solemn affair. It is a ton of paper and you literally feel like you are signing your life away. It is because they want to impress upon you psychologically the seriousness of the occasion. Even if you don’t plan on going after your family or friends, you want them to respect your money and what it means for you to put your trust in them. Have an attorney prepare the documents for you to send the message.
CONCLUSION
Money and blood rarely mix. However, if you are going to be treated like a bank, you might as well act like a bank. Contact DeVougas Law Group to prepare the documents to protect your interests.