Who better to put money into your brilliant business idea than people who can already vouch for you? Friends and family are an obvious source of funding. And in this era of ebbing small business lending by banks, if you don't have an interested investor, why not turn to mom, pop, and the rest of your clan?
"Trust. That's it. Hands down. Family members especially – they've watched you all your life," says Wayne Rivers, president of the Family Business Institute Inc., a family-business consulting firm based in Raleigh, North Carolina. When traditional funding sources aren't available, especially to young entrepreneurs who lack collateral, family members can bridge the gap.
Entrepreneurial relatives might say, "I started a business when your age: How much do you need?" But if expectations don't align, more than just your business can end up going under. Even a new endeavor that becomes wildly successful can wreak havoc on relationships.
To prevent shouting at the dinner table and lawsuit threats, pull together a careful plan that protects everyone involved. Here's how.
Pitching Your Business to Friends and Family: Do Due Diligence
The minute lawyers step in, they have a tendency to cause potential lenders or investors to run for the hills. Still, involving one is worth the reality check.
"An entrepreneur should sit down with an attorney up front before they make pitches rather than later saying, 'Let's get someone to bless this for everybody,'" says Greg Kruzel, a partner in the law firm Braun Siler Kruzel PC based in Scottsdale, Arizona, whose clients include entrepreneurs.
In addition, bouncing the business idea off an accountant and those who are already familiar with the market will help confirm that the venture is unique and sound. Kruzel describes a client who came to him as a potential investor in another person's startup. "He was being asked to invest $1.5 million in a venture for a software being developed in this industry," the attorney says.
Kruzel and his client found that a company already existed that was doing the same thing at a fairly high level. "It was a company that had been around for a couple three years. This other competitor here could squash him like a bug on a windshield."
Pitching Your Business to Friends and Family: Pick the Right Moment
Making the business pitch to friends or relatives shouldn't involve a surprise conversation. The person should have notice that there is going to be a serious talk.
"The first thing I would do is test the waters," Rivers says. Consider whether the friend or relative has ever put money into a new business before. Having money doesn't necessarily go hand-in-hand with being entrepreneurial. If your grandfather launched his grandchildren's careers, there's a pretty good chance of success. On the other hand, if no one in the family has ever had an entrepreneurial pursuit, a new proposition might be too daunting.
Pairing passion for a new venture with a receptive audience is necessary in order to move forward with a plan. "This should be win-win and business-like in nature," Rivers says. "It shouldn't be because Grandma feels guilty that you didn't get a birthday present when you were 14."
Pitching Your Business to Friends and Family: Have a Business Proposal Ready
Articulate exactly what the business will entail and the reason for starting it. Banks and venture capitalists require a detailed prospectus. So should friends and relatives.
"What ends up happening later on that can be problematic is that the expectations are not aligned," says Leslie Dashew, president of the Human Side of Enterprise and a partner in the Aspen Family Business Group, a consulting firm in Scottsdale, Arizona, specializing in family businesses. "Don't leave it to assumptions."
Rivers suggests reviewing the business plan in as much detail as the audience merits, including exactly how much capital will be needed to start up and to keep going. Often, he observes, it's easy to forget about operational costs.
Treating family and friends just like one would any other kind of serious investor can head off arguments later. Kruzel advocates sharing information. "I don't care if you're selling it to your brother, sister, uncle, or mom, you should be making full disclosures to them: full financial statements, tax returns, projections," he says. "If they knew the hazards of this business plan, at least you could sleep at night knowing you gave them access to any and all information."
Pitching Your Business to Friends and Family: Evaluate Financial Eligibility
Private equity investors have documentation showing that they are qualified and they must demonstrate that the money isn't enough to take them down. Likewise, any family member or friend interested in the business proposal who wants to invest or loan money should be evaluated to make sure they are financially qualified.
"If you're starting a business, you've got a 20 percent chance of making it within a year," Dashew says. The risks are extremely high. She recommends putting the warning in writing: "I don't want you to invest if you can't afford to lose this." Should the business go under, not only are loved ones out of cash, but there is also the added guilt of having been responsible for setting them back.
Business loans from relatives and friends can also be extremely problematic. "The borrower and the people loaning the money, they need to be clear that this is basically a lark," says Stephanie Brun de Pontet, an associate of the Family Business Consulting Group, a consultancy based in Marietta, Georgia, that works exclusively with family-owned businesses. "It would be stressful on a relationship if you borrow money and a few years later they need it back."
Pitching Your Business to Friends and Family: Decide on the Stakes
Loans and investments involve different risks. Brun de Pontet says the nature of the funding needs to be clearly stated. A loan, no matter how informal, should be written out contractually and include a time horizon. "For it to pass muster from a tax standpoint, it needs to be charged an interest rate that is reasonable or it's possible that the IRS would interpret that as a gift," she says.
Investments can create a different kind of challenge. Dashew gives the example of a father who invests with a son's business. "While it might not be explicit, the father is thinking, 'I have years of experience in the business world. I will be able to give my son advice and keep him from making mistakes,'" she says.
Brun de Pontet suggests outlining exactly how much voice the investor will get. "As a minority owner, what right do you have to communicate your expectations to the people with an ownership stake?" she says. "You don't want family members to be cranky with each other: 'I loaned you this money but you never listen to the suggestions I make about this!'"
Success can change the dynamics of the original agreement. Take an investment value that continues to remain at five percent, Brun de Pontet says. "All of a sudden $10,000 is worth $2 million. They have a two million investment in your business."
In a worst-case scenario, Kruzel says, the friend or relative who provided funding dies unexpectedly. The transaction becomes part of the estate and can be transferred to a spouse or children, essentially going to a third party.
Pitching Your Business to Friends and Family: Formalize the Deal
Planning for every eventuality should be decided at the start and agreed on in writing. Serious money might be exchanged over a handshake, but Kruzel tells entrepreneurs that they're selling unregistered securities. After all, any returns aren't made through the investor's work. Returns are based on others' efforts.
"That's a pretty big one," Kruzel says. "Sometimes I have that discussion with people and that's the only time they're in my office."
Once everyone is on the same page, it's time to bring lawyers back to the table, along with an accountant. Dashew suggests that the documentation make all conditions explicit. Whether the lawyer's fee is $5,000 or $10,000, the security is worth it, she says.
Friends can be just as tricky to deal with as relatives. "It's your friendship and you do want to tread lightly, both in terms of how much risk is that person capable of exposing themselves to financially, and balancing the expectations," Brun de Pontet says. For example, a friend who invests might feel entitled to a job.
Close relationships can easily tear apart when money is at issue. Kruzel points to Facebook as an example of what can happen when friends start a venture that becomes wildly successful without articulating rights and ownership. "It starts in a dorm room. Maybe one person thought about it and the other person ran and did it," he says.
Pitching Your Business to Friends and Family: Keep Communication Lines Open
Even with a formalized agreement, clear expectations, and a promising business plan, a startup can still fail.
"In the quiet of the night you have to confront your deepest fears," Rivers says. "If things go to hell in a handbasket, what am I going to do to make things whole should things go bad?"
When the business struggles, entrepreneurs might be reluctant to give friends and family bad news. "What's more helpful is to be honest and open and be able to say, 'We're struggling and here's what we're doing to deal with it,'" Dashew says. She invested part of her retirement in a high-tech company that her nephew is also investing in. When the company began to falter, she received more frequent e-mails describing what they were doing to stay on track, which she found reassuring.
Dashew grew up with a serial entrepreneur in the family. Her father started a new business at age 90. She remembers a time when she didn't own a jacket and another when her father was listed as one of the richest men in America. "I think entrepreneurs by definition are overly optimistic," she says. "They're less cautious or they wouldn't do it."