Finding the right type of business financing – or any financing for that matter – is one of the biggest challenges that entrepreneurs face. Unfortunately, a brilliant business plan (or idea) won’t help you much unless you have the money to launch the startup.
Asking your friends and family to invest in a business is a common way to get a startup funded. We are going to discuss the good, the bad and the downright ugly of this strategy. By the way, if you are looking to finance a business, you may want to check out our previous articles on realistic business financing options and on self financing.
Debt vs. equity
Basically, there are two ways that a person can invest money in a company. They can lend money to the company, which creates debt. Or, they can buy a portion of the company, which gives them equity. Every business financing option uses either one – or both – of these two alternatives.
Debt is very simple. A person lends money to your company and you agree to pay it back. They are compensated for their risk because the payback amount also includes interest. The person does not take an ownership stake in the company, and should not have any decision making powers. In many cases, you remain personally liable for the loan if the company goes out of business.
On the other hand, someone can invest in your company by purchasing equity. This gives them a piece of your company. They become an owner, which basically makes them your partner. Since they own the equity, you do not need to pay them back for the money that they provided. However, they will be able to benefit from any company profits and will have a say in how the company is managed. The investor will lose their investment if your company goes out of business.
Keep in mind that this is a gross oversimplification of your available options. However, it’s a good place to start. The first decision you need to make before approaching friends or family for money is this: what kind of financing do you want? Do you want them to lend you money? Or, do you want to sell them a piece of your company? Both have pros and cons.
Debt vs. equity – My personal thoughts
This is not a financial recommendation. However, I prefer to debt financing to equity. The main reason is that selling equity gives someone else an ownership stake in the company. This gives them some decision making power. You will also be working with this person as long as they remain an investor in your company. In my personal view, by selling equity you give up independence. And if you think about it, the thing that most entrepreneurs like about business ownership is just that – independence.
On the other hand, a business loan has a definite end. Once you have paid it off, you are done. You make (most?) of the decisions and you get to enjoy whatever benefits come after that.
Getting your financing from friends and family has some benefits. For starters, it’s easier to get than conventional financing. You can also get it faster, in part because friends and family won’t spend a lot of time doing any lengthy due diligence (to their detriment!). Lastly, most friends and family will be willing to give you flexible repayment terms. The latter is especially true for parents. These are all important benefits.
However, there is a reason for all these benefits. The bottom line is that they are doing you a favor. There is no other way to look at it.
However, there are some negative aspects to getting financing from friends and family. One problem is that things could fail to go as planned, thus you never get to pay them back. Most people, especially your family creditors, will feel very badly about this. More about this on the next section (“The Ugly”).
But that is not all. You are almost guaranteed that your new-found “creditors” will want to pitch in more than money. They may start offering unsolicited advice or start doing things on your behalf. This will be a problem if you don’t want – or don’t need – their advice. By the way, don’t try using a “silent partners” clause with them. I don’t believe in the concept of “silent partners”. In my experience, silent partners can be very vocal if their money is at stake.
Unfortunately, getting funding from friends and family can get downright ugly. It will likely create disputes since family relationships don’t always work well in professional settings. This is an issue that well known entrepreneur Rand Fishkin (of Moz) mentioned in his interview (question #3). You are almost guaranteed to lose the relationship if things go badly. Unfortunately, you could lose the relationship even if things go well for the business. I know this for a fact. I have been on the lending part of this equation and things have always gone badly. Yeah, I should have known better. This is why I am not a big fan of this type of financing.
Still want to go ahead? Some pointers
Asking friends to invest in your business is tricky. If you still want to get this type of funding, I suggest that you approach it professionally. Treat your family members in the same way you would treat professional investors. Show them a business plan and a presentation. If they decide to give you money, use an agreement that has been drafted by an attorney. And then, above all, honor the agreement and make sure you pay them back.
In closing, here are some good tips from the SBA on how to ask friends, and family members to invest in your company.