First, you have to determine whether the money is a “loan” or an “investment”. The difference is whether the money is at risk or not.
If the money is a loan then it is approriate to agree on a rate of interest and for you to sign a personal guarantee of the loan. I would expect to see a rate of return in the area of 10-15% on a private loan from an unrelated person. Securing that loan with an interest in something real, like real esate should lower that rate. (but then you would go to a bank and get the money for a lot less) Paying a percentage of sales or profit in this scenario is NOT appropriate; the rate of return should be clearly established.
If the money is an investment you need to do several things:
- Decide and agree how much of the business the investor will own.
- Decide and agree how much you will be paid to operate the business BEFORE the profit is determined. It is fair that you are paid a market wage for your labor.
- Decide and agree what the repurchase terms will be. i.e. how much will you pay to buy back the investment. When is this option available?
For example, if you agree that the investor will own 49% of the business and that you will be paid $15 an hour to work there the scenario might look like this: (profit in an S corp is paid in direct proportion to ownership)
Sales $500,000
Wages for you and your spouse $15 an hour 55-65K per year
Profit from the business (after owner wages) 50K
25K each for the investor and for you.
The major difference is that in an “investment” the money is at risk. If the business does not make money there is no return. If the business fails, the money is lost.
In a loan, the money is expected to be repaid regardless of business performance. There is still risk (bankruptsy) but the repayment is not dependent upon what the business earns.
Another idea is actualy to do both:
A. 50K loan to the business but personally guaranteed. Rate of interest agreed. Expectation of repayment whether the business succeeds or not. Target rate of return about 12% (private unsecured loan from an unrelated party) The risk and return are both lower.
B. 50K investment in the business. The money is at risk but the expectation of rate of return is more like 25-30% for an investment like this. That would mean you would set the proportion of ownership at a point that you all expect will produce about 15K in annual cash return. Risk and return are both high.
You should certainly incorporate this enterprise to insulate yourself from risk, define the proportion of ownership and so the business can take on obligations distinct from your own. You will also realize a tax savings on a portion of the income from the business (fica on the portion paid as profit) Since this is not passive income an S corp is more appropriate than an LLC.
Good luck to you in your endeavors!!