Sitting 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.

Whatever the terms, keep in mind that the investor usually comes attached to the cash. That's why you need to be careful, warns Case Western's Deeds. "You want to get the right people onboard," he says. "The wrong investors can suck up an amazing amount of your time and force you to divert resources away from building the business."

The wrong investors can suck up an amazing amount of your time and force you to divert your resources."

Indeed, pick the wrong investors and you may find that your personal relationships suffer as well. One southern California entrepreneur (who asked not to be named) learned this lesson the hard way. During the dot-com boom, he convinced 10 college buddies to put $150,000 into his software start-up in exchange for equity. Without really understanding what he was doing, he gave his investors control over any future financing arrangements that would affect the value of their equity stake. Unfortunately, when a venture capitalist came along and wanted to invest $5 million in the firm, the original investors vetoed the deal. "They thought that VCs were vampires, trying to steal their money," the entrepreneur remembers. The whole mess almost wound up in court, but at the last minute, both sides agreed to mediation and restructured the terms of the loan. The business survived, but the friendship didn't: The onetime college pals haven't spoken since.

But it doesn't have to end that way. Remember Chris Baggott, the dry-cleaning entrepreneur? In October 2000, he launched another business, ExactTarget, an e-mail marketing firm. Baggott again turned to friends and family--but this time, he went out of his way to emphasize the risk involved. "I said, 'Here's our business plan, but this is just a plan, and the chances are good that you'll never see this money again," he says.

Ultimately, he raised more than $1 million, and this time, it's going better. ExactTarget has grown from two to almost 70 employees over the past three years, and while Baggott won't share exact figures, he says sales grew 1,000% last year and more than 400% this year. Among his new investors: his father-in-law. How did he muster the courage to turn to him? "You've got to have supreme confidence that you're doing the right thing," Baggott says. "I knew I had a great idea, and I felt an obligation to let him in. Had I not let him in, and then I made money in this business, how much would that have strained our relationship?"