The right way to use friends and family to fund your business

Obtaining the cash required to fund your start-up can be a challenge. There are many different options out there when raising capital for the first time, however entrepreneurs often turn to their friends and family for funding...

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Funding from friends and family is popular for a couple of reasons. Firstly, it is easy for entrepreneurs to get heard. Venture capitalists and angel investors have a lot of start-ups knocking on their door trying to pitch their company, it can be difficult to get time with them.

Secondly, entrepreneurs are more likely to get the funding they need from friends and family, as they are positively inclined to help out a friend starting a business and say yes. This initial funding can help your business grow and improve your chances of getting investment from other sources.

However, just as going into business with those you know and love has the above advantages over other financing options, they also have unique disadvantages as well. 

For one, there is added pressure on the entrepreneur to not lose the money that their friends and families have invested. Building a successful business isn’t easy and takes a huge amount of time and dedication. The reality is that a lot of start-ups do not succeed and capital from friends and family can be lost with it.

If your business fails, unlike investors you have met on a professional basis, your friends and family will be a part of your life afterwards. The loss of their money is embarrassing for the entrepreneur and can strain relationships.

It is therefore important when accepting money from friends and family that they are completely aware of the risks and downside of lending money to a start-up. By doing this, it is likely only friends and family who can afford to lose the money will lend it helping to ease the stress on an entrepreneur’s mind.

Another issue when taking money from friends and family is working out a fair agreement. Fred Wilson, a successful venture capitalist and blogger, said: “it's tough to know how to price and structure an investment where the investors are close friends or family. You don't want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.”

Friends and family might say they are ‘giving’ you money for your business, but as the agreement is usually made in an informal way, misunderstandings can occur about what exactly the friend or family member expects in return for their money.

Cliff Ennico, an expert on managing growing companies says: “you may think it is a loan, which you will repay in time with interest. Your friend or family member, on the other hand, may think of it as an investment for which they will receive stock or an ownership interest in your business. That initial confusion may have bad legal consequences down the road.” 

Wilson advises friends and family financing as “convertible debt with a discount and a cap on the valuation.” Convertible debt is when a business borrows cash and the debt converts into shares at a later date. Often investors want a discount when the debt converts as compensation for taking the initial risk when the business was starting off.

Funding from friends and family can be the easiest source of funding to obtain but it can also be the trickiest as well. These people will be in your lives for a long time so it is important to be clear, open and fair with them. They are taking a risk on you when others wouldn’t and should be rewarded for it.

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