Guide to Lending Money - TheStreet

Guide to Lending Money

Before you invest in a friend or relative's small business, consider these factors.
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Blending strawberry smoothies for a living can be a pricey affair.

Brothers Kyle and Aaron Campos spent nearly $200,000 to open their Main Squeeze Juice and Smoothies cafe in Buckeye, Ariz., in 2005. Now they're experiencing year-over-year growth of 22%, which should increase even further with the franchises they have in the works.

The former computer programmers mainly used their own savings to fund the original venture; they also received a $35,000 bank loan and $20,000 from family and friends.

The friends-and-family route is one of the more popular funding channels for start-ups. In fact, Americans make 6.1 million friends-and-family loans per year for more than $89 billion total, according to

CircleLending.

Childhood neighbor James Rohl says he didn't hesitate to offer $5,000 to the Campos brothers, his old after-school basketball buddies. "I essentially wanted to invest in my friend. I wanted to say, 'I believe in you and I know you're going to do big things,'" Rohl says. Even Rohl's mom, Debbie, threw in $1,000.

They're all sweet gestures, but lending money to a friend or relative for their business -- whether start-up or established -- can easily turn sour. A return on your friendly investment is no guarantee. Not to mention that tangling money with friends and family can potentially create a web of resentment and anger when things go awry.

So before handing over any money, here's a guideline for potential investors.

Confidence Check

Whether to invest in a friend's business largely depends on how well you trust the relationship.

To view Farnoosh Torabi's video take of today's segment, click here.

For example, experts don't recommend investing in a new girlfriend's or boyfriend's business, since problems with the relationship down the road may affect the repayment plan.

Be confident in the business. Do the proper research by reviewing the business plan, enlisting an expert if you're not certain how to evaluate the paperwork. Also, many public libraries offer free resource centers.

It also helps to know whether any banks have offered the business funding already. Make sure the friend or relative is also investing a substantial chunk of his or her own money into the business. If they've got something to lose, they'll probably take the business more seriously.

Rules of the Trade

A simple handshake won't suffice. Minimize risk and get the agreement in writing through either a promissory note (they're available online) or by working with loan facilitators, such as CircleLending, where agents create a business agreement between two parties and help service the payment.

The Campos brothers are managing all eight of their family-and-friend loans with the firm. It costs $199 for documentation and $9 for each loan payment. CircleLending boasts an overall default rate of less than 5%.

The terms of any agreement should include a repayment schedule, the interest rate and a grace period.

"Talk over in advance what you're going to do if a payment is late," says Jim Smith, vice president of marketing and sales at CircleLending. He also recommends spreading out the repayments, as opposed to getting one lump sum back in three years. "Few small-business owners have the discipline" to pay a lump sum, Smith says.

It's also important to include interest rates or other incentives to make the investment worthwhile -- maybe even a section about receiving a percentage of the business's profits. Kyle Campos and his brother are offering their friends and family up to 9% interest. "We wanted to give them something better than putting their

investment in the money market," says Campos.

Finally, invest only what you can afford to lose. When Rohl gave $5,000 to the Campos brothers a few years back, he was a bachelor and held a well-paying software job. "If I didn't see the money come back it wouldn't have been devastating," he says "In my mind, that money's gone." Rohl views his now-monthly $86 deposit via CircleLending as an added bonus.

However, circumstances are now different for the 32-year-old. Rohl has since married and become a stay-at-home dad to his nine-month-old son. Giving away five grand now is not an option. "As much as I'd like to make that same decision

now, it wouldn't be financially feasible," Rohl admits.

All Things Considered

With about 100,000 businesses in the U.S. failing each year, according to

Score, stay realistic.

If there's any concern that the relationship will suffer if the deal falls through the cracks, investing in the business is not advised. Keep in mind, too, that if the investment goes bad, you may be able to write it off as a capital-gains loss (check with your accountant).

And some advice for those who decide

not

to lend money but don't want to seem cheap or unsupportive? "Just say your spouse said no," advises financial planner and attorney Gary Schatsky. Or say

TheStreet.com

did.

Farnoosh Torabi joined TheStreet.com TV in July 2006 as the site's first official video correspondent. Previously, Farnoosh was a business producer and on-air reporter for NY1 News, Time Warner's 24-hour news channel in New York City. Farnoosh is a regular columnist for AM New York and has written for Money, Time, New York Daily News and Newsday. Farnoosh is a graduate of Pennsylvania State University, with a degree in Finance and International Business and holds a M.A. from the Columbia School of Journalism.