I have always believed that the best way to finance a business is through self-financing. It has a number of advantages, if you can afford it. The most important one is that you have complete freedom to run your business as you see fit. You don’t owe anything to anyone.
As a matter of that, that is how I financed my startup a decade a go.
Unfortunately, this doesn’t always work for everyone. Sometimes, your business needs more money than you can afford to invest. Or, you simply have no money to invest whatsoever. Your only alternative is to look for outside financing.
Personally, I am not a big fan of asking friends and family to invest in your startup. It puts your relationships at risk – and that is too high a cost for me. However, if you are going to do as friends for money, might as well do it the right way. I am going to give you some tips on how do this effectively and in a way that tries to preserve the friendship.
The big question: Debt vs. Equity
This first question you want to ask yourself is whether you want to raise money by getting a loan or by selling equity. This is not an easy choice. Both have their pros and cons.
Getting a loan gives you money without having to give up any ownership in the business. Your friend lends you money, which you pay back according to a prearranged schedule. Since your friend doesn’t have an ownership stake in the business, they have no say on how it’s run – at least in theory. And, they have no right to future profits.
Loans can affect your cash flow due to the repayment schedule so consider them carefully. Also, they can encumber your personal assets. I like to think of a loan as being expensive upfront but cheap in the long run if your company succeeds.
Selling equity allows you to trade an ownership stake in your company for money that you don’t have to pay back. In exchange for their money, the investor now gets a share of the future profits and (usually) a say in the company. I view equity injections as cheap upfront and that is expensive in the long run if you succeed.
Assuming the business allows it, my preference is to use a loan rather than selling equity. Loans have a specific end date which gives you and your investors a clean exit.
Get advice beforehand
Before proceeding, consider getting advice from a CPA or an attorney – preferably both. This will be money well spent. They will give you specific advice on how to set up the loan or equity transaction in an effective way. Don’t avoid this step. Yes, it’s expensive but necessary.
Ask your colleagues or friends to refer you to a CPA / attorney that understands entrepreneurship. They all claim they do, but that is not always true.
How to ask friends to invest in your business
Raising money from friends should be no different than trying to get a stranger to invest in your company. Actually, you will have a better chance of succeeding if you treat your friends as you would treat a potential investor you have never met before.
1. Be professional
Above all, treat your friends the same way you would treat a professional or angel investor. It doesn’t matter if they are your drinking buddies or if you have known them since grade school. Separate your personal life from your business life. And when it comes to business, treat them professionally without exception. This should set the tone for the rest of the professional relationship.
2. Be honest
Create an investors presentation and give them an honest appraisal of the business. Make sure they understand the benefits and the risks of investing in your business. This includes the risk that the business could fail and they could lose all their money. This last point is key. However, many entrepreneurs avoid saying it because it’s uncomfortable.
Take the time to develop an accurate business plan and show them realistic sales forecasts. Never lie to them. Lying will get you in trouble and will jeopardize your friendship for ever.
3. Choose investors wisely
Never ask for money from friends that cannot afford to invest in your business. If you don’t think they can afford it, don’t ask them. Period.
If you are selling equity, consider asking only friends that can bring something extra to the company. This could be management experience, industry contacts, ideas, or just plain work. The last thing you need is a co-owner who has no idea on how to operate a business and brings nothing else than money.
4. Create a compelling presentation
Just like regular investors, your friends don’t have the time or inclination to read a 50-page business plan. At least, not initially. Instead, create a compelling investors pitch that outlines all the important details of your business. Spend some time doing this and practice your presentation before showing it to your investors.
By the way, having a business plan may come in handy later on. Savvy investors will want to read it before investing.
5. Have a lawyer create documents
Hire a lawyer to help you draw up professional loan or equity sale documents. You may be able to save some money by downloading a template from the internet and having the attorney modify it to fit your needs. This may be expensive but will protect you and your friends. Do not skip this step.
6. Honor your commitments
Once you have an executed financing agreement, follow it to the dot without exception. Meet all contractual expectations and make all loan payments on time.
7. Provide regular updates
Consider providing your investors with a regular update on your business. You will have to keep them up to date anyways, so it’s best if you formalize this process.
Use a prearranged schedule, such as every quarter or twice a year. Formalizing this step will also help ensure that you give each and every investor the same information.
8. Give them a chance to say NO
Don’t pressure or guilt your friends into investing in your business. Give them the option to say no and exit gracefully. Don’t hold any grudges if they decline to invest.
How to take no for an answer gracefully
You can expect that some – or even all – of your friends will decline your investment offer. This can be a painful experience for many entrepreneurs. You feel they are rejecting your dream, and therefore, you. Don’t take it personally. Your friends have their own reasons for not investing and you have to respect them. For example:
- They may not be able to afford the investment
- They may be saving money for something else
- They may not be comfortable investing in startups
- They may not be comfortable investing in your business
- Their adviser may have told them not to invest
Respect your friends right to say no. If they decline the opportunity to invest, thank them for the chance to present the business to them and move on.
Are there better options?
Before asking your friends for an investment, consider other options that don’t have the risk of jeopardizing friendships. There are a number of alternatives that don’t require involving your friend in your business. Here is a list that have some alternatives that you can consider.