Most entrepreneurs fund their businesses at least in part by raising money from family and friends. In these days of tight bank credit, that’s more common than ever.
It’s also asking for trouble. Your dear uncle might be happy to help you out, but, if your business tanks—and his investment sours—you could find it hurts your relationship forever.
“You’ve got to be prepared for the Thanksgiving effect,” says Edward Rogoff, professor of management at Baruch College’s Zicklin School of Business. “If your relative loses the money, you’re going to have some very unpleasant dinners.”
Rogoff points to the founder of a paper shredding company who, several years ago, accepted a $50,000 investment from an old friend. Much to his surprise, almost immediately his pal started calling him every day trying to find out how the business was doing. Ultimately, the company failed—and the friendship went down with the firm. “The entrepreneur felt his friend had showed a side he hadn’t seen before and the friend was bitter because he’d lost a lot of money,” says Rogoff.
The potential for such fiascos is why you need to step very carefully when taking money from family and friends. While there’s no guarantee you can prevent problems from happening, these steps should help.
Be smart about how you broach the subject. For one thing, all family and friends aren’t alike. Your favorite uncle, probably has different motivations for lending you money than, say, your former boss. Keep that in mind when thinking about your pitch. It’s unlikely anyone will demand the slick presentations expected by the professional investor. But you should have some materials in hand, especially if you’re approaching someone with a lot of business experience.
At the same time, there’s a delicate balance. For one thing, you have to deal directly with the potential for conflict. “Explain that you want the person still to be your friend no matter what happens,” says Rogoff. “Get it out in the open.” What’s more, you need to introduce your discussion in such a way that you—and your friend or relative—don’t lose face if you get turned down. “Pace the discussion in little steps,” says Rogoff. “And at every stage, give them an opportunity to say no gracefully.”
If someone you’d rather not take money from makes you an offer—say, your nervous, bossy cousin who drives you crazy--just tell him or her you’d prefer not to threaten your relationship by getting involved in a business arrangement.
Consider debt, not equity. In some cases, it might be safer to borrow the money, rather than accepting an investment. After all, if the exchange is structured as debt, then you simply need to pay the loan back. Should the person buy stock, then he or she has the right to intervene. If you decide to take the equity route, then you might try to make it nonvoting stock, to reduce the opportunities for meddling.
Offer them choices. You don’t have to structure the arrangement in the same way for everyone. If a friend would rather give you a short-term loan with a high interest rate and your aunt prefers the opposite, there’s no reason not to comply. You can also offer different repayment schedules—monthly installments, say, or a long grace period. Or tie payments to cash flow.
Get it in writing. Treat the deal like any business relationship. That means drawing up a contract as you would with an investor you barely know, with repayment terms and anything else that’s required. If you’ve agreed on a loan, hire a lawyer to draw up a promissory note. To make it really legit, make sure the interest rate isn’t less than the current official percentage. “Even if it’s your brother, you need a written agreement,” says Rogoff.
