Pros and Cons of Friends and Family Financing

The types of business success stories that make news typically involve hot young startup entrepreneurs landing millions of dollars in venture capital. That’s why it may come as a surprise to you to learn that the average startup entrepreneur finances his or her business using personal savings or money from friends and family financing.

What are the pros and cons of financing from friends and family? Here are some pluses and minuses to consider.

Pros of friends and family financing:

• They trust you. No one believes in you like your friends and family do. Assuming you have a good relationship with your family members, they’re naturally inclined to lend you money—after all, you’re family!
• They care about your success. Friends and family members are motivated to help you financially because they want to see you succeed, unlike outside lenders and investors who are motivated solely by their own financial gain.

Cons of friends and family financing:

• Friends and family may feel like they can’t say no when you ask them to invest in your business. Because they don’t want to cause hard feelings, they may be reluctant to point out weaknesses in your .
• If your business doesn’t return a profit for friends and family investors, or you’re not able to pay back the loan a friend or family member has extended, you could lose more than money—you could lose a valuable relationship.

Don’t let the risks of friends and family financing scare you away. By treating money from friends and family properly, you can have the best of both worlds—the capital you need and the relationships you value. Here are three steps to take:

1. Pitch the opportunity professionally. It’s OK to broach the subject informally with friends and family to see if they’re interested, but if they are, you need to make a formal presentation, just as you would with any lender or investor. Prepare a detailed business plan that explains your business model, your marketing plan, your financial projections and what the loan or investment will be used for.
2. Don’t do a hard sell. It’s easy to feel pressured when a family member needs money. After you make your presentation, give friends and family members plenty of time to go away and consider their options. Don’t push, and above all, never take money from anyone who can’t afford to lose it—no matter how much they insist.
3. Draw up the proper paperwork. If a friend or family member gives you a loan, you need to put it in writing—including the amount of the loan, the interest rate, the term of the loan and how and when you will pay it back. If a friend or family member invests in your business, it’s even more crucial to document their role in the business. How much equity (ownership in the business) will they receive in return? Will they be an active advisor, partner or board member of your business, or simply provide financing? It’s important to clarify everyone’s expectations. If your brother-in-law expects to be involved in all major decisions and you just thought he was handing you a check, both of you will be in for an unpleasant surprise.

As you can see, financing from friends and family is more complex than just a handshake. But if you take the time to get it right, both you and your “financiers” will be rewarded.