Money from relatives and friends can supplement the business financing you're receiving from other sources -- or even fill a critical gap in starting up your business. Getting friends and family involved in business financing is not uncommon -- nearly one in ten Americans reports a loan outstanding to a relative or friend. This is not surprising, as both you and your family member or friend can stand to benefit from the deal.
Here's what you need to know before you launch into a sales pitch: the basics of private financing, how to present your proposal, and steps to formalize the deal. (To learn about the different options for raising money from family and friends, read Nolo's article Raising Private Money: Gifts, Loans, and Equity Investments.)
Making it Work for Everyone
Raising money from family or friends may seem straightforward: they do something nice for you, and you owe money to somebody who is understanding. However, getting private money has even more advantages for both sides -- though certainly you should tread lightly when making your personal relationships financial.
Advantages for You, the Business Owner
Raising money from family and friends has a number of advantages, especially as compared to other financing alternatives.
- Private money may be available when other money is not. If you've already maxed out your personal sources of cash, but don't have the collateral or revenue to attract bank or professional equity financing, the advantage of private money is obvious: It's your best, and sometimes only, source of start-up capital.
- Private loans may be cheaper than other sources. Family and friends, unlike banks, credit card companies, or even microlenders, are typically not out to make money off the deal. You could end up paying zero interest or interest at below the market rate.
- Private loans offer flexibility. Loans from banks and other institutions are nearly always standardized, but private lending is flexible: You can both set up a customized repayment plan (for example, a six-month grace period followed by 12 months of interest-only payments, followed by a graduated payment schedule for 36 months) and adjust your repayment schedule if your business hits a bump.
- Private money represents validation from key supporters. The start-up phase of a new business is a very stressful time, and having someone you know express his or her belief in you and your idea by writing a check can mean a lot.
- Private money requires less work than other sources of equity capital. You don't have to sell yourself nearly as hard to people who already know and trust you, and this can serve as a dry run for later attempts to secure professional equity financing.
Advantages for Your Lender
You needn't see yourself as preying on the charitable instincts of your family and friends. They also benefit in several ways from investing in your business.
- Investing in you can satisfy your investor's altruistic motives. Those closest to you might help finance your business because they have an unselfish desire to support you and want to see you succeed.
- Investing in you can satisfy your investor's self-interest. Your investor can make money from investing in you -- often, more than they might get from a comparable investment in a savings account or CD. Alternately, they might enjoy the thrill of getting involved with a successful business.
Special Considerations When Mixing Money and Relationships
Of course, there are potential pitfalls and hassles that come with mixing money and relationships. Family members may feel that you "owe them one." Or, you may not like having some lenders or investors watching your every move, then criticizing your new car or family vacation. And, not every lender will be sympathetic as you try to explain your need to reschedule or skip a payment.
For the most part, these are issues that can and should be dealt with in advance. Make the arrangement as professional as possible. That way, your private lender or investor will treat this as business, not a personal arrangement. You can, for example, offer collateral to secure your friend or family member's loan. And, you should agree on clear and definite terms for any loan, including payment dates, interest rate, and penalties, if any. If your friends or family make equity investments, you might agree to give them a right to share the proceeds from the business's assets if it's sold.
How to Ask Friends and Family for Financial Support
The biggest hurdle preventing many entrepreneurs from getting private financing is simply the fear of asking. You can overcome this fear with a combination of careful preparation and choosing a time and place that makes you and your prospective lender or investor comfortable.
Before actually asking for the loan or investment, plan out how you'll approach your friend or family member.
- Decide when and where to discuss the proposition. Decide whether it's better to bring your request up in a casual conversation or at an informal meeting. In either case, you should choose a setting that's suited to your relationship -- for a very close relationship, it might be in the potential lender's home at a time you regularly visit them, whereas a restaurant or café is a good location for meeting someone with whom you're not especially close.
- Plan what to bring. Think about what you can bring along to illustrate your plans, such as a brochure, sample product, or company logo, but remember that this is an informal situation where detailed plans and promissory notes would be out of place.
To actually make a compelling pitch, start by getting your potential investor excited about your business idea. Then, ease into your request when it seems to arise naturally. If the conversation goes well, wrap up by explaining that you'll shortly be sending a copy of your business plan and a request letter; don't try to formalize the loan or investment right then and there. If the conversation doesn't go well, give them time to review your request and maybe your business plan, then follow up to determine what your prospect needs to get to yes.
Document the Loan or Investment
Once someone has agreed to participate in financing your business, it's crucial to get the agreement in writing. In the case of a loan, you and your lender would draw up a promissory note detailing the amount you'll owe, your repayment schedule, and penalties if you fail to make a payment. In the case of an equity investment (which assumes that you've set up a corporation or LLC), you would negotiate a stock purchase agreement that includes your disclosures about the business and a description of the investor's ownership rights.
For more information on every aspect of private financing -- from making your pitch to preparing the appropriate paperwork to maintaining good relations with your lender or investor over the life of your business, get Business Loans from Family & Friends: How to Ask, Make It Legal & Make It Work, by Asheesh Advani, (Nolo).