Whether you’re just getting started as an entrepreneur or you need some outside investors to help your established business, friends and family are a time-honored source of funding. With bank loans harder than ever to obtain for small businesses, friends-and- family investments have become even more important for lots of entrepreneurs. If you want to have a successful friends-and-family round for your business, you are going need to get these three things right: the selection, the pitch, and the structure.
If you have a decent-sized set of friends and family members, you have to make sure you select the right ones to pitch your business to. And that doesn’t just mean avoiding your crazy Uncle Billy.
Start by putting together a list of all your potential investors and then try to answer a few questions about each one. Does he have any entrepreneurial experience himself? Could I see myself taking direction from her if she became an owner? Is he in a position to withstand losing money if my company goes under? Ultimately what you are looking for are your contacts who would be comfortable with an illiquid investment, who can absorb a loss on their investment without financial hardship, and who might make good business partners down the road.
Just because you are pitching to people who know you better than anyone doesn’t mean that you’re excused from doing a professional job. Treat friends and family as you would any other potential investors, it shows them that you take your business—and their money—seriously, and it’s great practice if you’re eventually hoping to talk with professional investors like angels and venture capitalists.
Try to pave the way for the conversation that needs to take place by keeping your inner circle up to date about what you and your company are doing, and possibly dropping in the fact that you may be looking for investors. When it’s time to give the actual pitch, let your best prospects know that you want to have a serious talk. And be prepared. That means having a thorough business plan and sharing it in as much detail as your audience is interested in hearing. You also need to be willing to share all financial documents related to your business, including the precise amount of capital you need to raise.
While it can be easier than you might think to find friends and family who want to help your business succeed, far too may entrepreneurs fail to properly structure these investments. And that can lead to problems down the road, for both your initial investors and for your company when you go looking for the next round of funding.
If you have someone willing to lend you money then you don’t have to give up any ownership in your company, but you do need to structure the loan properly. It needs to be written out as a contract, include a time horizon, and most importantly, pay a reasonable interest rate. If you ignore that last criterion the IRS may consider your loan a gift, leading to a potentially nasty tax bill for your investor.
If your friends and family insist on an investment rather that a loan, consider offering them convertible debt—a loan that converts into equity if you get a larger round of financing in the future. Convertible debt has a number of advantages over equity, including the fact that you don’t have to set a valuation on it, as you do with equity. If you value your company too high when issuing equity in the friends-and-family round, your initial investors will see their stakes significantly diluted if you find professional investors in the future. By issuing convertible debt you can put off the difficult task of valuing your company until you have professional investors involved.
And finally, just as you would when dealing with professional investors, make sure to have a lawyer and an accountant approve all agreements that you strike with friends and family.