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Common Practice
Using cash from FFF to start a business is quite common. Roughly half of startup entrepreneurs get financial support from friends and family members in beginning their venture. According the Global Entrepreneurship Monitor (Babson & London School of Business), $50 billion to $75 billion is invested annually by friends and family in U.S. startups. This is two to three times the amount of money invested annually by angel investors or venture capitalists, which invest approximately $20 billion per year in new businesses.
Bringing on a Co-Founder
While your friends and family present a great opportunity to raise capital to launch your business, you and your co-founders should plan on personally investing in the business. Investors at any stage like to see that you have committed personal funds in addition to sweat equity. First and foremost, if you aren’t willing to assume any of the risk, neither will investors. Secondly, by putting some skin in the game you are showing your commitment to the company.
Many entrepreneurs who have a great idea but no personal funds to invest in the business will seek out a co-founder prior to approaching their friends and family. This can be a great strategy if you are prepared to give up a large portion of equity. As they are founding and financing the organization, they are going to require a significant share of the company — and rightfully so.
Your co-founder will likely be in this for the long haul, so it is crucial you find the right person. Below are a few tips for finding the right startup co-founder for you and your business:
- Find someone with a complementary skill set to yours
- Find someone that is an expert in key areas of the business that you know nothing about
- Find someone that shares your values and work ethic
- Seek out references of people that have worked with a potential co-founder and do your due diligence
- Take your time to find the right person
- Know what you are looking for
Approaching Friends & Family
Your friends and family are your most immediate source of funding beyond your own pockets. Chances are, they already know about your business idea and have seen your efforts to grow a company. Your friends and family have an interest in seeing you become successful and be happy in your career. Because of these relationships, they are happy to help you out in a way that makes sense for them financially. While you can structure your friends and family capital as loans that you plan on repaying, your friends and family can also be a source of gift money that they do not expect you to repay.
If you do set up a private loan agreement with a friend or family member, there are multiple advantages to the loan agreement that you cannot get from the bank. The first advantage is the moral support that your friend or family member will provide. They know you personally and are happy to watch you succeed, but they are also willing to help keep you motivated through the rough times your company will inevitably face. The second advantage is the flexibility in setting the terms of the loan. Your friend or family member lender can set an interest rate that is lower than that from a bank, if they set an interest rate at all. You can also agree to a repayment schedule that fits you best. Since you are not dealing with a commercial institution, you are not limited to specific amounts to be repaid at specific points of time. In addition, while you must not take advantage of the generosity of your friend or family member’s loan, you do have a bit more wiggle room to alter the repayment calendar if necessary.
By taking the loan seriously and presenting your friends and family lenders with the legal documents of a legitimate business transaction, you open the discussion to the issues that are unique to mixing friends, family and money. Many issues can be avoided by identifying them and discussing them up front. Some of these issues include:
- Disappointing your friend or family member if your company fails: It is crucial to explain to them that failure is a possibility with any new business venture. You can offer reassurance by presenting the option to secure the loan. In the event that your company fails, with a secured loan he or she will be able to recoup their investment.
- Being unable to keep up with your repayment calendar: In this situation, you are best advised to be as proactive as possible with keeping your friend or family up to date on your financial situation. Letting them know as soon as you suspect that you may not make a repayment deadline, you can discuss an alternate pay arrangement that eases some of the strain on you.
- Getting into a “favor” war and feeling like you owe your lender something beyond repayment: To avoid a friend or family member using the fact that they loaned you money against you, make the transaction as formal as possible. If you offer an interest rate that is competitive with other investment opportunities, such as CDs, your lender will be assured your repayment with interest will fully reimburse them for their loan.
- Giving your lender the impression that they are actively involved in management: Communicate to your lender that your loan is purely a business transaction, not an opportunity to act as a quasi-employee of the company. Make sure all your discussions with the friend or family member avoid topics related to management, as you don’t want to give them the impression that you are seeking their advice.
Pitching Your Business
After you have narrowed down a list of ideal lenders, you have probably realized that despite their ideal lender status, they may each necessitate a slightly different approach with your pitch. If it’s someone you are close with and see often, you could use a more informal approach when asking for a loan. If it’s a business contact or someone you don’t know as well, it would be appropriate to schedule a time to meet with them formally to discuss your business. When approaching this second group, a formal “elevator pitch” would be ideal. However, with your close friends and family this method is too formal; instead, utilize what is called a “kitchen table pitch.” Compared to an elevator pitch, the kitchen table pitch adapts to the pre-established relationship with the potential investor. It is delivered to ensure that if and when the discussion leads to investment, the relationship is still protected.
For potential lenders who are very close to you, it is probably wise to find a way to get them to offer to help before you ask for a loan. If your potential lender knows you are excited about getting your business off the ground, they may naturally ask what they can do to support you. That would be a perfect segue into asking for their financial help. If that situation does not arise naturally, another method to initiate the conversation is to tell them how much money you need to get the business started and ask if they would be interested in investing a portion of it. Make sure to let them know why you have considered them for the opportunity so they see themselves as being able to provide value to you beyond the amount of the loan.
Make sure you give your potential lender some time to roll the idea around on their own before you assess their first reaction. Your potential lender is likely to need some time to review their finances and get outside opinions before they agree to go forward with the loan. Proactively address the concerns you can predict by telling them how their money is protected. If they are worried, for example, that you will be unable to repay them, tell them it is possible to secure the loan with collateral. But listen carefully to objections they have; some people simply will not be interested no matter how many assurances you give them.
