Banking Close to Home- Starting a business with help from friends and family doesn’t have to mean making enemies.

Eric Martin began to think seriously about starting his own business when he was told last New Year’s Eve that he’d soon be out of a job. Gallerani’s Café, the Provincetown, Mass., restaurant where he’d been keeping the books and playing host for two years, was closing. The actual inspiration for opening his own place came after he relayed the bad news to a couple who had been coming in for years. "The wife actually got teary-eyed," Martin recalls. At that moment, he realized he could count on loyal customers. "There was no reason I couldn’t do it if I found space and some financial backing."

By Eileen P. Gunn Business 2.0

Getting the space (a 100-seat restaurant a mile from Gallerani’s) was relatively easy. Getting the capital was considerably more difficult. When the funds he and colleagues pooled to open Jackson’s, a steak and seafood house Martin named for his dog, fell $5,000 short, Martin began looking to friends and family. Topping the list of likely lenders were Anita Butler, the teary-eyed cafe regular, and her husband, David. "I started off the conversation with the Butlers by saying it’s hard to borrow money from friends," Martin says. To reassure David Butler that everything would be kept professional, Martin suggested a new online service called CircleLending, which helps borrowers and lenders draw up contracts and repayment schedules. Butler thought that made sense. "It was good to have a neutral arbiter who will suggest something that works for everyone." It was by no means a sweetheart deal — a 10-month loan at 15 percent — but the restaurant opened in time for the tourist season.

Seed-money loans from friends and family are as much a part of entrepreneurial legend as garage workshops. Bill Gates and Steve Jobs got their initial funding that way. Atlantic Records founder Ahmet Ertegun borrowed his grubstake from the family dentist. As accurately as anyone can measure, there are $65 billion in friends-and-family loans outstanding. The problem is that not every business funded with this type of loan will grow into a Microsoft (MSFT) or an Atlantic. History suggests that some 14 percent of these loans will never be paid back.

In that high default rate, Asheesh Advani saw an opportunity. A former World Bank consultant who had worked on microloan programs in developing countries, Advani figured that the informal, handshake nature of friends-and-family loans was part of the problem. So three years ago he set up Boston-based CircleLending to play the middleman in these transactions. By using standard loan documents and elementary technology — e-mail and electronic transfers, for example — CircleLending makes it simple to both structure a loan and pay it back. The company charges setup fees ranging from $49 to $1,500, plus 1 to 2 percent of the payment.

Advani discovered that simply drawing up loan agreements can bring defaults down to 5 percent, much closer to credit cards’ current default rate of 3 percent. "When you use automatic payments from a bank account, the default rate drops even further," he says. For their part, lenders and borrowers have found that going through CircleLending can prevent some awkward conversations at family gatherings. So far the site, http://www.circlelending.com, has processed about $3 million in loans.

While it isn’t necessary to use an intermediary to borrow from or lend to someone you know, it is essential to formalize the arrangement. Kevin Meuse, an estate planning lawyer with Boston’s Kirkpatrick & Lockhart, warns, "Any loan for any amount should be documented in some way." For most deals involving friends or family, legal software like Nolo’s Quicken Lawyer can provide all the fill-in-the-blank forms you need.

It’s also a good idea to check with your accountant or financial planner: A poorly structured loan could earn you some unwanted attention from the Internal Revenue Service. If you can’t prove you’ve charged interest or made an attempt to collect the debt, for example, the IRS might decide you haven’t made a loan at all, but rather a gift; if the amount was more than $11,000, your estate could then be liable for a gift tax, which starts at 41 percent. The same is true if you try to be nice by charging your nephew below-market interest rates: The IRS says the interest-rate break constitutes a gift as well. In some instances, the government will also consider it a gift if you could have collected delinquent interest but didn’t.

An advantage to a service like CircleLending is that it keeps reminding the debtor of the obligation. That persuaded Atlanta businessman Tom Bining to help Eric Bobby, a friend and former colleague at industrial conglomerate United Technologies. Bining’s $5,000 loan provided stopgap funding for Bobby’s efforts to jump-start CityKi, which installs Internet kiosks in inner-city stores. "Having the repayment land in the bank on the same day every month," Bining says, "makes the whole thing worry-free."

Bobby actually did have trouble making his payment one month. "I let CircleLending know, and they e-mailed Tom to ask if I could defer that payment," Bobby recalls. "He OK’d it." Though CityKi is still struggling, Bobby has just about paid off the loan. Best of all, he and Bining have remained friends.

http://www.business2.com/articles/mag/0,1640,51370,00.html