Raising Capital from Friends and Family: Gifts, Loans, Equity
Most entrepreneurs who are starting a new business venture need capital to fund their business plans. Typical sources of capital include personal saving, home equity loans and loans or investments from “Friends and Family.” Friends and Family capital typically is provided as: 1) a “gift” 2) a “loan”, or 3) an “equity investment.”
Gifts from Friends and Family are great but the person making the gift may have gift tax implications, for example an individual can currently make a an annual gift of $14,000 tax free but anything above that amount requires a tax to be paid by the donor (note: a husband and wife can each make a $14,000 gift tax free, see: Frequently Asked Questions on Gift Taxes).
Loans can be provided with simple Promissory Notes that set forth a Principal Amount, an annual Interest Rate, a Payment Schedule and a Maturity Date. Sometimes entrepreneurs will use what are called “Convertible” promissory notes with Friends and Family and other early stage investors. Convertible notes allow the lender/investor to convert their loans into equity when the Company makes its first equity offering after operations begin. This equity is typically in the form of preferred equity (i.e. preferred corporate stock or LLC units) and the lender is able to convert his/her or its loan and interest into equity at a discount. The Promissory Note will be reported as a debt on the Company’s financial statement and the interest when paid will be income, taxable to the lender and a deductible business expense to the Company on its income statement.
Equity can be sold to a Friends or Family members, the challenge in this case is that the initial value of the equity is extremely difficult to price since the Company has not started operations. Selling equity to Friends and Family is tricky because once someone is an owner there is a new level of responsibility that entrepreneur takes on. Additionally, selling equity requires compliance with federal and state securities law even though the entrepreneur is dealing with Friends and Family members. If equity is sold to secure capital, then the Company and the equity owners will need to make some tax decisions to maximize tax savings both when Company is making or losing money (see: Should My Company Be LLC or S Corp?).
Common sense suggests that regardless what type of investment or loan an entrepreneur secures from Friends of Family, that some professional advice and recurring communications are critically important.
Professional advice is recommended for a number of reasons, first, there are civil and criminal laws that govern the sale of securities (e.g. equity and convertible notes), there are also tax consequences for both the lender/investor and the Company which need to be understood by both parties.
Communication with Friends and Family who trust the entrepreneur enough to offer financial support is no different than dealing with a commercial bank. In fact, having clear, honest and on-going communications is critical not only for maintaining the business relationship, but even more so to preserve the trust of the personal relationships when dealing with people who offer help from a sense of love and respect.
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