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We love our children. They are our flesh and blood. But lending them substantial amounts of money to set up a business brings serious risks and can raise punitive tax complications. This kind of financial backing is not uncommon — but both sides need to think twice before investing.
In my time as a chartered financial planner, I’ve seen it time and again — family business loans going sour, with consequences for lender and borrower. One client, lent a substantial amount by his parents for a start-up, ended up declaring the business bankrupt after a few years, putting a strain on family relationships for far longer. In another case, a business owner was hit by a large tax bill after the death of the parents — who three years earlier had gifted him a large sum to back his company.
New research by Charles Stanley shows the extent to which family and business enterprises are linked in the UK. Of the 500 business owners and entrepreneurs we spoke to, 19 per cent sought funding for their business from the Bank of Mum and Dad, while 10 per cent went a step higher to the Bank of Grandparents, or other family.
At a time when cheap liquidity options are drying up, parents are clearly becoming a popular source of start-up capital. And even as those businesses become more established, owners and entrepreneurs remain reliant on family for subsequent funding. We found that 15 per cent of respondents have used inheritance for further growth investment, while 13 per cent leaned on their parents for a corporate cash top-up.
The Bank of Mum and Dad can provide an instant injection of capital into a young, upcoming business and save a business owner the trouble of having to produce a five to 10-year business plan or meet an agreed repayment schedule — as banks would traditionally require. But orthodox credit tests are there for a reason and bypassing them can turn out to be a cause of regret.
There are risks to the business owners themselves. First, loan arrangements made between parent and child are often relatively informal. Can the Bank of Mum and Dad recall the loan at any time — causing potential disruption to the business — or demand an interest payment if it had originally been set up on an interest-free basis? Could the lack of a contract or agreement lead to potential issues down the line?
If the money was a gift from a parent directly to the business owner (and not the business), the entrepreneur may be personally liable to pay inheritance tax should that parent not survive for seven years after the gift is made. If the original gift has subsequently been invested in the business, the potential tax liability will still fall on the business owner personally.
When it comes to risks for parents or grandparents, the obvious ones are the loss of capital and the emotional pressure to reduce or remove any interest payments depending on how the business performs. After all, around one-third (34 per cent) of new UK businesses cease trading within their first two years of operations, according to Experian research.
Beyond this, family lenders run the risk of the four Ds:
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Disagreement between parent or grandparent and the business owner. What impact would a falling out or argument about the loan have on the relationship and subsequently with the grandchildren or wider family?
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Debt. What happens to the parental loan in the event of the business falling on difficult times or becoming insolvent? This is also an issue if the business owner is declared bankrupt. How will the original loan be repaid, and where would parents sit in the pecking order of creditors?
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Divorce. If the business owner divorces, the capital loaned by parents could be among the assets expected to be diluted after a decree absolute is served.
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Death. How would the death of the business owner impact on the business and the original loan repayment to parents?
There is also an opportunity cost — the money given for a business loan cannot be spent elsewhere. If you’re trading off your daughter’s business plans against your grandson’s private school fees, you’re demonstrating favouritism. This could lead to family grievances and disputes down the line.
None of us would lend or gift money to our children and think that any of these negative things are going to happen, but I see it in financial planning conversations with clients all too regularly.
With many of my business clients who take on bank borrowing I help them protect their bank creditors with so-called “key person” insurance. This type of cover would pay out to the bank in the event of the business owner’s demise or business interruption should they be diagnosed with a critical illness.
In this way the bank’s exposure is protected and it won’t rely on the business continuing to trade in order to satisfy its repayment schedule. If the Bank of Mum and Dad is to operate in this space, it should look to have the same level of protection as a commercial bank.
So if you’re a parent (or grandparent, or very kind aunt or cousin) who is fortunate enough to have the money to help your family, where should you start? Given the complexities and risks, I believe you should avoid funding a loved one’s business, instead reserving your financial firepower for personal legacies.
Family wealth planning can help children reach the first rung of the property ladder or contribute to a junior Isa for new family members, among other productive options. With careful financial planning, this can be done in a tax-efficient manner — but I’d implore corporate loans to be left to the experts.
Neil Torney is director of financial planning at wealth manager Charles Stanley
