Small Business

Peer-to-Peer: The Bank of Mom

Written by PROFIT-Xtra


Last issue the president of an Edmonton-based startup wrote to ask PROFIT-Xtra readers:

“My company is just over a year old. I started it with my own money, but in order to finance our growth, I need another $50,000. My mom has generously offered to lend me the money — which I want to accept — but my business partner thinks we should sign a formal loan agreement. I’d like to know from experienced entrepreneurs if this is truly necessary.”

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Reader responses

Carol Ann Ballantyne:

I am a “Bank of Mom” who loaned money to a business started by my son and two friends. We prepared a short document signed by all of the shareholders acknowledging the loan, the interest rate, terms of repayment, etc., and also guaranteeing it.

I believe the formal document was the right thing to do since all of the shareholders — not just my son — now understand what the terms are and understand that they are responsible for it. Without the document, it would be easier for the others not to feel responsible for it. A formal agreement also demonstrates good business practices, just as the company should be doing with all other business arrangements it enters into.

Kelly J. Ramsay:

Anytime you borrow money, whether for personal or business reasons, you should have some form of written agreement in place. The reason is to define the amount, terms and repayment plan of the loan, default clauses and penalties, and to provide for unexpected situations such as bankruptcy or death. Having a formal agreement protects both you and the lender and formalizes your arrangement. Additionally, there may be tax and reporting consequences for both parties, which the agreement will address.

What would happen if, God forbid, you were to become incapacitated and your partner were to take over the company? What if he decided he wouldn’t continue to service the debt or repay the loan because it really was a personal loan to you from your mother — one to which he, or the business, was not a party? Without a formal agreement in place, your mother could find herself out $50,000, without any recourse available. Even if she were giving you the money as a gift, I would have a grant agreement in place.

Dirk Mast:

Sign a formal loan agreement to keep it all above board and strictly business€¦after thinking twice about whether or not you should borrow from family at all! An arm’s-length agreement for borrowing might cost you more, but it would have more cross checks and accountabilities that might save your business down the line.

Here’s how it could go bad. What if your mom died suddenly, and all the rest of the family knew nothing about the details of the loan? So they discover you owe $50K to the estate, and they want the money back in the kitty…now! What if you can’t repay it immediately? What if you’ve missed some payments or interest and your mom hasn’t kept accurate records? Who will believe you? All of a sudden, you might be considered the black sheep of the family. Strained or broken family relationships could be the result.

It’s not worth it. Cover all the angles and make it a clear and detailed written agreement, and let the rest of the family know. They may not like it now, but you won’t like it much if the former scenario plays out.

Wayne Edgar, Trade Exchange Canada:

Depending on whose interests you are trying to take care of in this matter, there are a few ways of looking at this.

1. For the protection of your mother’s interests, there should be a formal agreement in place to protect her in the following situations: if the company changes ownership; if it enters financial difficulties and other creditors are put ahead of her; or if it become very successful and the ownership decides there is no urgency or need to pay back the “loan.” In the latter case, because there is no formal documentation in place, the ownership may not regard it as a loan to the company, but rather as a personal loan to you.

2. For the company, having a formal contract that details repayment terms, interest rates, etc. is important to keep all your finances in order. People have a habit of forgetting where money came from and when it is due to be repaid when there is nothing to back it up.

I know of several instances where companies have been lent friendly money and then, when things started changing, so did people’s perceptions of how much was lent, why it was lent, when it was to be repaid and so on.

For a new small business, the sooner you start thinking big the better. (Would WestJet take out a loan with no documentation? Probably not.) Finances are the key to any businesses. So, treat this situation the same way you would if you were a big company and you’ll save a lot of headaches down the road.

Stephen Semple, THINC. Strategies:

You should have a formal loan agreement for a few reasons. If the company has financial difficulties, your mother is recognized as a creditor. If you have personal guarantees, it puts your partner on the hook. That’s only fair, given that he is benefiting as well. And lastly, if things do go wrong and you are not able to pay your mother back, she can write off the loan and potentially get a tax deduction.

Moscou “MC” Cote, Voyages Constellation:

The short answer: you should always document loans!

Too often entrepreneurs are hyped about their business to a point where they don’t feel that something could go wrong. Why else would we work the hours we do? However, as the saying goes, an ounce of prevention is worth a pound of cure.

Time and time again, I have seen that when cash flow gets tighter than normal, SME owners will hold off paying themselves their full salary, knowing that the situation is temporary and by the end of the year they’ll get it back in full. Other types of unconventional loans we make to our business are similar in that we expect things to go well. A loan from family members or friends is exactly the same; otherwise, we would not risk their money!

If everything returns to normal, great! But it’s terrible if it doesn’t. I recommend whenever you loan money to your business, you do it with a legal lien as a secured creditor (we call these “asset mortgages” in Quebec, with our civil law system, but the common law system used in the rest of Canada has similar instruments). That way, if an unforeseen problem arises, you will have a better chance of getting some or even all of your money back.

In my previous example of salary reduction, you should pay yourself the full amount of your salary, then loan it back to the company. The same applies to a family loan. Whether your family loans it directly to your company, or loans it to you and you then loan it to your company, you should make it a secured loan.

This is even more the case if you have one or more business partners. Even if you are on the best of terms with them, should something terrible happen the partner’s heirs might not find it very credible if you claim that his or her share of the company is worth less than the book value because the company owes you an amount of money that hasn’t been documented.

Of course, this type of loan will show as a liability for your company, and bankers will frown over it. The easiest way to deal with this to subrogate your asset to the bank’s benefit [make the bank the creditor for the amount of the loan].

A more reliable method of doing this, albeit more complex, is that you take your mother’s $50,000 loan under your name and put it into a term deposit at your bank, also under your name. Then use the term deposit as collateral to secure a loan or line of credit for your company from your bank, along with a full “all-assets” type of guarantee to the bank.

This way, should the business ever fold, the bank will take hold of all assets and proceeds thereof, pay itself and then release your collateral — or at least, whatever is left after any shortfall is refunded from it. Any other creditors will not dare attack the bank’s status as a secured creditor (because it is a bank), as long as this arrangement had not been made knowing that the business was about to fold.

This kind of strategy is often seen as apocalyptic, and again, entrepreneurs tend not to believe it could happen to their business. But I compare it to a wearing a seat belt. Whenever you get in your car, you put on a seat belt (or should!), not because you expect to have an accident, but because it would be wise to be wearing one just in case you do.

For his answer, Moscou “MC” Cote will receive a copy of Advantage Play: The Manager’s Guide to Creative Problem Solving, by David Ben.

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