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Six Tips for Managing Friends and Family Financing of Your Small Business
Published on Jul 4, 2012
Read our article, 'Six Tips for Managing Friends and Family Financing of Your Small Business' at 'Time to Start Up,' the small business blog by BizFilings.
If you're an entrepreneur, chances are good you owe a great deal of your business acumen to your family and friends. They probably taught you some of the your earliest lessons, from how to handle money to how to tie a tie. And now that you're poised to start a company, they might be willing -- even excited -- to help fund the enterprise.
Your Aunt Sally, your college roommate, your dad's wealthy golf buddy -- all can be great sources of early-stage financing, but there's also some risk when personal relationships become business relationships. The following tips can help you successfully manage this potentially tricky kind of financing.
Details, details, details. An angel or venture capital investor, as well as a bank, will want to see a detailed business plan before ponying up any money. Your friends and family believe in you, so they might be willing to offer some cash without seeing an in-depth plan, but this can lead to trouble down the road. A good rule of thumb is to treat your friends and family as if they were strangers, and to pitch them your business plan as if they were not predisposed to supporting you. This will set a tone of professionalism and can benefit you by ensuring that your vision for the business is viable and that you have a solid plan for what you will do with the money you raise. It can also help from a marketing perspective: Because your friends and family are probably not professional investors, you will have to figure out the best ways to describe your business to general consumers in order to describe your plan to them.
Put it in writing. A handshake and a thank you might be all your Uncle Joe expects after handing over some money, but you should be ready with some formal paperwork. It doesn't have to be as detailed as a venture capital term sheet, but a basic promissory note will still spell out the basic conditions of the financing, such as interest rates and conditions of repayment.
Specify debt or equity. Some friends and family might assume that by handing over some cash, they're buying in to the company -- that is, that they are getting some equity. But you probably want to avoid an equity round of financing until your business can be properly valued and you are willing to dilute your own stake in the enterprise, so you might be better off treating friends and family contributions as loans. This means setting an interest rate and a repayment schedule. The rate should probably be set near the current commercial interest rate. You could consider tying your repayments to a percentage of cash flow, so that paying down debt is not too much of a burden as you try to build the business.
Seek high-net-worth individuals, but spread out the risk. Your backers are taking a risk: No matter how well-considered your business plan, there is still the possibility that your enterprise will not prove successful. Therefore, it's wise to seek out financing from individuals who can afford to lose the money they loan or invest. However, accepting a large sum from one person can create a high-pressure situation, so it's preferable to spread out the risk among several people. It's also a good idea to secure a small bank loan, as this will show your friends and family that the business is not entirely dependent on their dollars, and will give them confidence, knowing that the business was vetted by a bank and was deemed worthy of support.
Consider contingencies. There have been notable exceptions, but generally speaking, a bank is a stable institution and you can confidently enter into a long-term business relationship with one. Families and personal relationships are subject to unforeseen change, though. Divorce, death, estrangement, loss of a job -- these things sometimes happen suddenly and can create financial complications. If you've put your financing agreement in writing, this provides some legal protection for you. But before accepting money from friends or family, it's a good idea to consider the possibility of these sort of events occurring, thinking about how they might impact the financing, and weighing the risks carefully.
Communicate with siblings and other family members. If mom and dad or grandpa and grandma are giving you substantial sums of money for your business, this can create ill-will among your siblings or other members of your generation in the family, who might worry that part of their potential inheritance is being gambled on your enterprise. Bringing them into the loop and being as transparent as possible can work wonders, as can the option of early inheritance, if your parents are in a position to give you a portion of your legacy.
Although there are definitely risks when it comes to family and friends financing, the benefits are are also substantial. Not only can it be extremely rewarding for them to see you succeed and to know they contributed, but by successfully managing this kind of financing, you will impress venture capital investors down the road.