When Your Friends and Family Help Fund Your Business

Summary: Friends and family are often the primary funders of startup businesses. Before asking yours to invest in your business, know what you are getting into and how to structure these transactions.

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More than 85 percent of all startups are funded by the entrepreneurs themselves or their friends and family. But getting funding from those close to you is a slippery slope. Gratitude notwithstanding, this is a business transaction, and with that comes certain expectations and concerns.

The first, and most vital, decision you'll make when reaching out to family and friends is whether you will offer an equity interest in return for funding or just ask for a straight loan. Many experts advise sticking to loans, which have far fewer strings or conditions attached than an equity interest. Once the loan is paid back, that's the end of the deal. With an equity interest in your business, the person providing the funds may want some say in its operation. This might not be feasible for a variety of reasons, be it expertise, personality, or proximity. Borrowing is cleaner and, as long as your business works out, far less problematic.

Loans

With any loan, provide a written contract that includes an investment letter specifically stating all terms of the loan, any applicable interest rate, and what happens if you default. Also note who approached whom about the financing.

An even better solution is to ask a family member or friend to serve as a cosigner for a loan rather than directly providing money to your business. If they can put up an asset to back your loan, the only thing they actually need to provide is a signature. This is a particularly attractive option if the person providing the financing is retired and doesn't want to part with the cash up front.

Equity Interest

You may be fine with forfeiting a bit of decision-making freedom to your new equity partner, but know that setting up an equity transaction is far more involved than getting a loan. Make sure you have the time and resources to handle this transaction properly.

Using a lawyer to guide you through an equity transaction is essential. First, you need to put a value on your company, factoring in assets and potential to generate revenue, and eventually profit, before multiplying that total by a common number for your industry. It's also advisable to structure the company as an S corporation or a limited liability company, as these structures allow investors to deduct corporate losses on their personal income taxes.

Most significant, though, is to make sure you comply with federal and state securities laws. A common mistake is not properly disclosing risks to nonaccredited investors, defined by the Securities & Exchange Commission as those with a net worth of less than $1 million or an annual income of less than $200,000. There are exemptions, known as de minimis exemptions, which your lawyer can verify.

Final Considerations

In both loan and equity scenarios, a common mistake is overvaluation. Obviously you won't try to treat your friends or family unfairly, but you may be unsure of your future company's appropriate valuation, and your friends or family will almost certainly know less than you do. Driven by the optimism required for success often unintentionally leads entrepreneurs to overvalue the business. If you budget your future expenses based on an incorrect 20 percent overvaluation, you'll be 20 percent short when it comes time to pay back the loan or pay a share of the equity holding, making for an awkward dinner conversation at the next family get-together.

Before accepting any financing from people you are close to, stop and ask yourself if you will be able to fulfill the promises you've made. You're not just checking yourself but the people financing your idea as well. Are they clear and comfortable with all the terms of repayment? And perhaps most important in this transaction, will your relationship survive if your business does not? If you can answer yes to each of these, say thank you and get your business up and running.

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Business Takeaways:

1. Family and friends financing typically comes in the form of a loan or an equity stake. Loans are straightforward transactions that end when the sum is repaid. Equity stakes give part ownership and are more complicated and time-consuming to structure.
2. Overvaluation is a common mistake in friends and family transactions. Make sure you get an accurate valuation before structuring a loan or equity deal.
3. Before you accept financing in any form from friends and family, be sure you will be able to meet your obligations to them. Broken promises can destroy important relationships.

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