When business owners borrow start-up capital from family members or friends, it's best, most CEOs agree, to prepare for the worst -- before it happens. "I didn't factor in the possibility of problems," recalls Lew Hoff, owner of Bartizan, a $7-million manufacturer of credit-card and data-collection equipment in Yonkers, N.Y.
Hoff financed his start-up with personal funds, loans from his mother and brother, and a Small Business Administration loan, but the fledgling company still needed more capital. He couldn't go back for more, so, he says, "we made another arrangement through an attorney friend of mine, who had a client who borrowed money from a bank and lent it to us." Hoff planned to pay the loan back in less than a year but ran into a cash crunch instead. "My friend's client got angry at him, and he was peeved at me. I bought the client a necklace from Tiffany's, but my friend and I didn't talk for 10 years."
One way to safeguard the relationship -- at a cost -- is to tie financing to equity rather than a loan. Stephen Davies, founder of U.S. Computer Group, a $25-million computer-maintenance company in Farmingdale, N.Y., gave equity to a friend who invested $120,000 in his start-up. But Davies needed several additional infusions of capital and delayed his requests for money so long that he was "in a poor negotiating position." He adds, "The toughest thing is making a conscious decision to accept dilution of your ownership in order to get the capital you need. But when you're seeking money because you've exhausted other cash resources -- instead of simply to pursue growth opportunities -- you've got very little choice."