Online funding management systems have made it popular and convenient for entrepreneurs to ask for and collect startup funds from family and friends. Hundreds of now successful young businesses got their early boost from benevolent relatives and friends. Whether startups choose to use sites like Kickstarter and GoFundMe, or whether owners approach family and friends in person, it’s become commonplace and even acceptable to solicit friends and families for money to bootstrap a business.
There are significant risks associated with asking for and taking money from these sources, however. The potential hazards are both personal and business-related, and any attempt to do so should be undertaken with caution. It’s a good idea to consult with your CPA for some of the steps mentioned below. In the meantime, here are some of the pros and cons related to asking friends and family to help fund your startup, as well as some considerations to bear in mind.
You Place Your Personal Relationships at Risk
Startups are inherently risky business. In many cases, when funding is still to be obtained for prototyping and testing the market, proof of concept hasn’t yet occurred. As an entrepreneur and business-minded person, you’ve likely already done a ton of research, and you understand that the business is a venture, not a guarantee.
But your relatives and friends, who may not be business-savvy themselves, probably don’t fully realize the risk they’re taking by investing in your startup. You can tell them. You can sit down with them with stories and pen and paper and emphasize how they might never see that money again. But their motivation for wanting to give you the money could get in the way of their fully realizing that risk. They may be motivated by the idea that they could make a profit, by their love for you, or by their trust in you that you are clever and you know what you’re doing. These are all things that will a) prevent them from looking at the risk objectively, and b) make their loss ten times harder to bear if worse comes to worst.
When or if the day comes that you have to tell them their money’s gone, they may not remember the warnings you gave them. They may find it very hard to swallow that they made the decision of their own volition and their investment was a request, not a demand. They might not remember all that. However, they will clearly remember you taking their money, and they will clearly remember you not giving it back. That makes for some very awkward family gatherings—for the rest of your life.
Again, we’re talking about the worst case scenario here, if your startup doesn’t succeed. This isn’t to say that you have any worse chances than anyone else for your startup to succeed; these are just possibilities that you should think about before asking friends and family members for funding.
You Don’t Know Where The Money’s Coming From
When you get a bank loan or an investment from a venture capitalist, you have some idea that the money is coming from some kind of fund or source that's been set aside to give loans and assume a certain level of risk.
When you get money from friends and family, you don’t know where the money’s actually coming from. If you did know, you might think twice before asking your mom or uncle or best friend for money to gamble on your business idea.
For all you know, that money could be coming from dad’s retirement account, which he emptied out because you’re his son and can do no wrong. Your best friend might have secretly liquidated his kid’s college fund to give you for your startup.
Even if you dare ask where the money’s coming from, chances are you’ll get a smile and a pat on the shoulder and a “Don’t worry about it.”
That’s not good enough. There’s a reason why financial managers set up boundaries for people who want to invest in the stock market. They don’t want naïve investors mortgaging their house and going broke, and neither should you.
The Right Way to Get Friends and Family Funding
Of course, with shows like Shark Tank hyping up the generosity of friends and family who support entrepreneurs, you’re probably going to be tempted to do it anyway. If so, here is the right way to get friends and family funding without jeopardizing so much.
Set Limits
Make a cap for any single investor who is not a professional investor. For instance, don’t allow any one person to invest more than $1000. This helps to prevent magnanimous donations from friends and family who may not be able to truly afford it.
Make it Official
Make every contribution official, whether it’s $25 or $500. Making it official means signing paperwork, which you should either have a lawyer to write up, or get docs online. Everyone should have a record of any funds they provided for your startup, as well as details about interest, repayment, etc.
Provide a Written Prospectus
When you take the time once to prepare a written prospectus, you can just hand this out to anyone who is thinking of investing in your startup. (Provide digital versions if you use an online funding site.)
A written prospectus ensures that everyone gets the same information, and shows that you were open and forthcoming regarding the business details and the risks involved.
If you have a startup and you’re thinking of going the friends and family funding route, consider not doing so. Before you risk your personal relationships, make sure you explore all other avenues. As an entrepreneur, you should be able to think creatively about finding alternative means to fund your startup. And as always, talk to your CPA before starting any new business.
by Kate Supino
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