Family Loan: If You Borrow Money from Your Family, Protect It

Many small business owners borrow money from their family to support a business endeavor. Family loan is natural and occurs all the time. Unfortunately, because it is family loan, it tends to be treated loosely, less formal transaction than if money is borrowed in the normal course of business, and loans of this type rarely carry a note or UCC filing, or even a written agreement.

It makes little sense to treat your family in such a shoddy manner as you are really sacrificing their protection if you ever get into financial trouble, and this happens every day. Most family lenders say, "I can trust so-and-so... I do not need a note or a UCC filing. My relative will pay me back." It is not about trust between family members, it is about priority and payback, and protecting yourself and your family in a default situation.

Additionally, it is entirely possible (and even likely) that family loan may be borrowed even before the bank lends. Thus, the family loan is on file in front of the bank's, assuring your family priority in the case of default, which can be very helpful to the borrower for many reasons.

An astute banker or bank lawyer may require you to subordinate a family loan to a bank loan, thus removing the family from first position to collect. Though diluted, significant power remains if the family loan is documented and publicly filed (and thus considered a legitimate obligation which must be respected and dealt with) and this can play an important role in the workout scenario. The bias of the lenders, bank and SBA is that a family loan from a family member need not be respected or repaid, and can be ignored and rolled over for the benefit of the bank. Proper filing prevents such a cavalier attitude.

This is exactly what will happen unless the family loan is documented, collateralize and publicly filed. This does not mean your family member will hard collect, or foreclose (or even collect at all), but it does create a barrier between the bank and your assets that may be very beneficial to your loan workout and survival, as well as making certain your relative's money does get returned to them if possible.

The point being, if your family loan for your new start-up is handled impeccably from the start, in default that will serve valid purpose as the terms are enforceable and thus it must be respected and dealt with. If not defined properly, the family loan will be ignored, and not only will a loss occur, but you will have lost the protective benefit of such a filing.