Small Business

Peer-to-Peer: “Should I formalize a loan from my father-in-law?”—the best advice from PROFIT readers

Written by ProfitGuide Staff

Question

Last issue, the CEO of a Vancouver-based tech startup wrote to ask PROFIT-Xtra readers:

“My 18-month-old company is still in startup mode. We’re doing well so far, but money is tight. My father-in-law has generously offered to give me a loan with some favourable terms. I’m very grateful and have suggested we hammer out a basic loan agreement. He says there’s no need, that blood is thicker than water and he trusts me to pay him back. Still, my gut tells me to get it on paper. What should I do?”

Submit a question.

Best reader responses

Don MacKay, Amex Broadway West Realty, Vancouver:

You absolutely should document the loan. Two of many reasons:

  • To ensure that your father-in-law gets paid if something should happen to you and there are funds for settlement.
  • So he can have a tax deduction for his investment, or should the business fail!

Michael Caron, Northbound Learning Inc., Mississauga, Ont.:

Having been in this situation in the past, I would highly recommend that you formalize the agreement for three main reasons:

  • It ensures that there are no misunderstandings that can come back to haunt you down the road. I’ve been involved in many a situation in which one party says at a later date, “Oh, I thought we had agreed on this, not that.” Most often, it’s simply a case of details getting foggy over time, but it can lead to unnecessary disagreement and conflict. You especially want to avoid this with family.
  • It shows that you are treating your father-in-law with professional respect. It will help position you as someone who takes commitments seriously.
  • Situations can change. It sounds like you have a terrific relationship with your father-in-law right now, but, as we all know, relationships can change. If this happens, you will both be happy that you papered the deal properly.

Kelly J. Ramsay, Montreal:

The short answer is that you should definitely formalize your agreement.

There are several reasons for wanting to do so, even though it may take longer initially. The most obvious is to keep the books in order and fully document the company’s liabilities. But aside from that, it would also be a good way to further build the company’s credit, and you could leverage the agreement to obtain additional financing. As well, having such an agreement formalized with a family member will avoid misunderstandings and could save you a great deal of grief later on that could impact both your business and personal lives.

Taka Sande, Bigen Africa Services (Pty) Ltd., Johannesburg, South Africa:

The flexibility of family members makes borrowing from them much easier and advantageous compared to dealing with a financial institution. Family members can agree to lend without security, or with less security than a bank would accept. They may also agree to lend at zero interest, or at a low rate. They may increase the repayment period. They may be willing to vary the terms of a loan. And they may require none of the finer details or a business plan.

As a result, there are more defaults on family loans than on ones from financial institutions. The saddest part is that family loans do not just carry financial risk but also relational risk, in this case your marriage.

In general, if financial institutions do not want to give you a loan, it means you are a high risk and therefore your family should not give you a loan either. Maybe the father-in-law should consider the reasons why the banks are not offering you a loan in the first place.

When you get a substantial loan from family, it is advisable to make an agreement. Make everything formal and business-like, including presenting a detailed business plan. The agreement’s terms should include a repayment schedule specifying dates, amounts and interest rates, as well as what happens if you’re unable to pay back the loan, a description of how the money will be used, etc.

An agreement will secure you, your business, your father-in-law, the money involved and, in this case, your marriage as well. Many things could happen. You could die, the business could shut down, your father-in-law could die or you could get divorced. All these possibilities must be considered, discussed and agreed upon. The father-in-law must not lend what he is not prepared to lose.

It may also be good to give your father-in-law a shareholding in the company, especially if the loan is long term. In this way, he can also be responsible for the outcome of the business deal.

Lastly, I advise you to get professional advice on how to write this agreement and on the resulting tax and interest-rate implications.

For his answer, Taka Sande will receive a copy of How Did I Get Here? The Ascent of an Unlikely CEO by Tony Hawk.

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Originally appeared on PROFITguide.com
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