The vast majority of new businesses are self-funded, but the second most common financing method is through friends and family. Typically, those closest to you are the most likely to believe in you and your startup idea, they know your capabilities, and they want to see you succeed. However, money issues have a tendency to cause rifts in even the closest relationships, so it is critical that you plan ahead and handle all friends and family deals as professionally as possible.
There are basically two options for securing friends and family financing – loans or equity stakes. Loans are basic – your friends or family front the money for your startup and you (the business) pays them back over time at a reasonable interest rate. Equity stakes provide the investor with a permanent piece of the company. They do not necessarily get back their original investment within a set time period, but they are entitled to a set share of the profits through the life of the business.
Most family & friends equity stake investments stem from a mutual admiration – they will risk their the money for startup because they are confident that you will succeed, you are willing to give up a portion of profits because you are happy to share with these particular folks. However, without a detailed plan in place, these relationships can devolve very quickly into anger and resentment and can be devastating to both your personal and professional success.
The trick to handling equity stake investments from those close to you is to clearly define what it means for each party. The investor must understand that they are putting their cash at risk. If the business fails, repayment is not an option (if they want a guaranteed repayment, it is a loan, not an equity stake). The amount of return they receive will depend on the agreed upon portion of ownership and the overall profitability of the company.
Think through exactly how much ownership you are willing to trade for the capital your family & friends will provide. In most cases, you will want to at least keep a 51% stake so you have ultimate control of the venture. But giving away nearly half the profits before you even start is not always the best idea, either. Do not let desperation to secure the cash push you into an unfair situation – if it is your idea, your work, and your time that are going to make the business successful, the value of the initial investment may be far less than it seems when you just really, really need the cash.
It is essential to work through all of the details with your equity investor before the deal is made. Will they have any decision-making power? When will they receive distributions for their share of the profits? How will those distributions be calculated? What if the business fails? What if it succeeds beyond your wildest expectations? Talk through every possibility and make it clear that business is business – investment in your startup should not be an emotional issue.
Money and relationships can be a difficult mix. The excitement of going out on your own should not cause personal problems with those closest to you. All the potential resentments and falling out can be avoided, however, by simply putting in the time and effort to handle the equity stake agreement as professionally as possible. Dealt with correctly from the start, creating financial partnerships with friends and family can be a win-win situation for everyone involved.
