Asking any startup founder if they would ever “invite” a friend or family member to “invest” in their startup generates an emotional reaction. Actually, there is a lot of disagreement about this question.
Many founders caution that you should never ask friends and family to invest in the startup. They tell you stories of broken families, soured friendships, and failed investments. Others suggest it is a good idea, and they point to family-funded ventures that did very well.
So, what’s the right answer? Should you or shouldn’t you ask friends and family to invest in your startup? There is no simple answer. But if you choose to pursue these investors, there is a right and ethical way to do it.
In this article, you will learn:
- Ways that your friends and family can invest in your business
- Disadvantages of having friends and family investors
- Advantages of having friends and family investors
- How to let them invest in your company – ethically
How should people invest in your startup? Equity or debt?
Investors can put money in your startup in various ways. In this article we do not cover the complex financial instruments used by angel investors, venture capitalists, and investment professionals. We focus only on the instruments used by regular friends and family members: debt and equity.
By the way, despite the complex names, most forms of business financing usually boil down to debt, equity, or some combination of both.
What is debt?
You incur debt when your friend or family member lends money to your business. Loan payments are amortized over a period of time, and once all installment payments are made, the debt is satisfied.
Debt can be secured, which means that it is backed by specific collateral. If you do not pay the loan, the lender can foreclose on the collateral as a form of repayment.
On the other hand, debt can also be unsecured. This means that there is no collateral pledged to back the debt directly. However, holders of unsecured debt can still take your business to court for lack payment. And if they win, they get a judgement which can be used to encumber collateral.
Lastly, some loans are personally guaranteed by the business owners. This guarantee adds a level of security for the lender because the owner is personally responsible for payments if the business defaults.
One important feature of loans is that the relationship terminates once the loan is paid. The investor does not get any ownership in your business. Also, in theory, the lender has no say in how you run your business. I say “in theory” because the reality is often different.
By the way, if you think that an institution will give your brand new startup a line of credit, take a look at the qualification requirements. They won’t. At this stage of the game, the only loans you can get will come from friends and family.
Another way to finance your company is to sell equity to your friend and family investors. This option provides you with immediate funds to launch and grow the business. It provides your investors with a piece of your company and a say in its management. Basically, you are trading a piece of your company and independence for immediate funds.
There are ways that allow you to sell equity while keeping control and voting rights. Realistically, you can expect that your friends and family investors will want to have a say in their investment.
Unlike a loan, an equity sale does not have a repayment schedule attached to it. The equity holders get paid only by profits and distributions. As such, they share in the risk/reward of your startup.
Disadvantages of friends and family investors
The main disadvantage of getting funded by friends is that you are putting your relationship on the line. Do you want to risk losing a friend or the respect of a family member over an investment? For many people, it’s a price that’s too high to pay.
Additionally, your new investors may insist on having a say in the company – even if they only loaned money to you. The same applies to so-called “silent partners.” Truth is, few silent partners ever remain quiet when their money is at stake. Most people are quite vocal. Wouldn’t you be?
Lastly, your friend and family investors may lose all or part of their money. As the company founder, you are personally responsible for that. I can assure you that few will forget that fact and you will carry that burden for a long time.
Advantages of friends and family investors
Contrary to popular belief, there are some advantages to having friend and family investors. The most important one is availability.
Getting a business funded is extremely difficult. Angel investors and venture capitalists reject the majority of deals they review. Banks don’t finance new business. And few entrepreneurs have the resources to go at it themselves. Your friends and family know you and what you can accomplish. They may be the only ones willing to give you money.
Lastly, there is the benefit of paying them back – and then some. If your business does well, they will reap the rewards of getting paid back and making money on their investments. This does happen, though not as frequently as people hope.
By the way, if you are looking for funding, here are some realistic financing options to consider. They are a good way to avoid involving family and friends.
For the record, I am not a big fan of involving friends and family in business. It’s too messy and my limited experience with it has been bad. This is one reason why I have never taken any money from friends or family for my business – I self-financed my company. Period.
Having said that, if I had no other choice, I’d prefer incurring debt rather than selling equity. Note that this is not professional advice; it is just my preference. This is why:
- Debt has a clear exit. Your last payment finishes the deal
- Theoretically, debt keeps friends and family members out of my business (in theory)
- You keep 100% of your ownership stake
- Debt doesn’t force you to value a business at a stage where it cannot be valued reliably
I recommend against taking money from friends and family. However, I have some guidelines to consider if you choose this type of funding.
How to ask friends and family investors – ethically
If you decide to take money from a friend or family investor, I suggest you follow these steps. There are no guarantees you will avoid all problems, but it helps improve your chances.
1. Treat them the same way you would treat a professional investor
Perhaps the most important advice I can give you is that you should treat your friend and family investors the same way you would treat outside investors. While discussing business, put the friendship aside and treat them professionally. This step alone goes a long way.
2. Ask selectively
Don’t ask for money from anyone and everyone who can invest in your business. Ask only those who have the money to lose and who can contribute something of value to the company. Additional contributions could be advice, contacts, or anything that is crucial for your business success.
By the way, if they can’t understand your business model or market, they should not invest in it. This rule is very important.
3. Use professionally created documents
Pay an attorney to create proper loan or equity sale documents. Yes, it’s expensive. But these documents are critical for your business. And it relates to rule #1: an outside/professional investor would expect and demand attorney made documents.
4. Set expectations correctly
In the excitement of their business, many startup founders set high expectation for performance. Few of those expectations ever materialize. Ultimately, you end up with broken promises and soured relationships.
Make sure that your investors understand the true risk and reward of your business. This means telling them that they may lose 100% of their investment. If I were you, I’d emphasize this last point. Total losses are not uncommon.
5. Keep them informed
Keep your investors up to date regarding your company’s performance. Providing regular updates of good or bad news may be difficult at times, especially if things are not going as planned. But you still have to do it – you owe it to them.
6. Never (ever) lie
Never ever lie to your friend and family investors. Even the most honest person may be tempted to tell a white lie to avoid disappointing their friends and family. Don’t do it. Always tell the truth, even if it is really bad news. They may hate the news, they may be angry at you (hopefully temporarily), but they will respect you. No one ever respects a liar.
There is no easy way to go about this. Asking friends and family members to invest in your startup is a delicate business decision that can have lifelong consequences. If you choose to do it, make sure you handle it the right way. Lastly, here is some additional advice on asking friends/family to invest in your business.
Image: Fotolia Jakub Jirsák