Blood Money
Hitting up family and friends is the most common way to finance a start-up. It's also the riskiest.
Published December 2003
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COMMENT ON THIS ARTICLESitting behind his desk at a marketing firm, Chris Baggott often daydreamed of owning his own business. In 1992, he finally took the plunge. At the age of 31, he quit his job and bought Sanders Dry Cleaning, a local store that he eventually built into a chain with seven outlets. To make it happen, Baggott borrowed $45,000 from his father-in-law, James Twiford Anderson, a physician who also agreed to cosign a $600,000 bank loan.
With the financing in place, and 10 years of marketing experience, Baggott thought he was set. And then the whole "business casual" trend caught fire. "People stopped wearing suits," Baggott recalls. Revenue fell to just $60,000 a month, far short of Baggott's original projections of $110,000. What's more, he owed $14,000 in monthly payments to the bank. Propping up the business with credit cards, he began missing loan payments--and the loan officer's phone calls went straight to his father-in-law. Says Baggott: "He'd call us and say, 'What the heck is going on here?' And then he'd have to write a check to cover it from his own funds."
Eventually, Baggott felt he had no choice but to sell the business, pay his debts, and move on. But there was one investor he couldn't repay: his father-in-law, who ultimately lost tens of thousands of dollars on the venture. "It was painful," Baggott says, though his father-in-law was "great" about it. "You win some, lose some; it's trite to say, but it's true," says Anderson, who knows from running his own practice and from some real estate ventures that things don't always go as planned. "I know whatever project Chris goes into, he puts his heart and soul into it." Still, Baggott felt the business losses put a strain on their relationship.
If anything puts family members' love to the test, it's asking them for money. Yet it happens every day. In fact, investments by family and friends account for more than 70% of all venture dollars for start-ups, according to a recent study by Babson College, the London Business School, and the Kauffman Foundation. On average, investors sink $1,667 a year into businesses owned by friends and family, and some invest far more--an average of $255,000 a year for top investors.
The trouble is, entrepreneurs who turn their loved ones into creditors put more than just their financial futures on the line--they're putting their most important personal relationships in jeopardy, too. "It's the highest risk money you'll ever get," says David Deeds, an assistant professor of entrepreneurship at Case Western Reserve University in Cleveland. "The venture may succeed or fail, but either way, you still have to go to Thanksgiving dinner." Fortunately, there are ways to increase the odds that your relationships remain harmonious as your business becomes a financial success.
A classic mistake is hitting up friends and family too early, before a formal business plan is in place, says Stephen Spinelli, director of the Arthur M. Blank Center for Entrepreneurship at Babson. No matter how excited you are about your idea, you need to be as rigorous as you would be if you were wooing the most jaded banker. That means supplying formal financial projections, as well as an evidence-based assessment of when your loved ones will see their money again. Why? For one thing, it reduces the likelihood of unpleasant surprises. It also lets your investors know that you think of their funds as something more than Monopoly money. What makes business sense makes relationship sense, too.
Before you ask, think about how to structure the arrangement. Are you willing to give up equity? Or would you rather pay interest on a loan? The answers to these questions have major implications for both your business and your personal relationships. That's what Jill Crawley discovered three years ago, when she and her husband began plans to open Coriander, a 50-seat restaurant in Sharon, Mass. Two friends expressed interest in investing, but as the discussions progressed, it became clear that the parties were looking for different things: The Crawleys wanted a loan, while their friends wanted an ownership stake in the restaurant--something the Crawleys suddenly realized they had no interest in giving up. They ultimately raised $75,000--including low-interest loans--from their parents, other close family members, and a couple of close friends. "These are people who sincerely want to see us realize our dreams," Crawley says. "They're not going to be hanging over our shoulders and looking at our books."
Many entrepreneurs prefer debt, because it's cheaper over the long haul and involves no loss of control. Plus, you can deduct the interest as a business expense. On the other hand, if your business expects low cash flow for several years, or if you want to make your balance sheet look stronger because you're planning to borrow more money from an independent third party, a deal that involves equity could be preferable.
