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Have You Got the Stomach to Finance Your Business Using Money from Family and Friends?

I’m of the opinion that the best way to finance a new business is via the “3 F’s”: Friends, Family, and, for lack of a better term, Fools. Of course, the risk and headache you undertake when you accept money from relatives and close friends is often more aggravating and gut-wrenching than simply taking money from a faceless third party, like a bank or a venture capital firm. Unfortunately, however, because bank and venture capital financing is usually not viable for startups (and I’ll discuss why next week), new businesses are often left with no other alternative than to hit up the 3 F’s.

So, do you like your friends, family members and relatives? Want to continue to have a warm, fuzzy relationship with them? (I’m perhaps assuming too much here, but stay with me.) If the answer is yes (or even if it’s no), and if they’re considering providing funds for you to get your business off the ground, or to keep it running through a rough patch, then take heed of the advice I’m going to discuss here: come to an agreement with them in writing. BEFORE they give you the money.

Perhaps the best way to explain why you need to arrive at an agreement in writing with your family members or friends before they stroke you a check is by discussing what the agreement should, at minimum, include. Here are just a few of the issues you’ll want to focus on while you’re putting together some sort of document to memorialize the arrangements:

  • Did you discuss whether the money was going to be classified as debt (a loan) or as equity (an investment) in the company?

Debt and equity are treated very differently for tax and legal purposes, and they have very different characteristics with respect to repayment and expected returns. Lenders won’t (or shouldn’t) expect much more than 6% – 12% annual interest, plus return or amortization of principal on some agreed-upon schedule. Equity investors, however, often have visions of buying a Greek island with the triple digit returns they expect to make via an investment in your company. Which would certainly help out the Greek economy, these days.

If the money is a loan, you’ll want to deliver a Note to your lender (yes, even if that lender is a relative or friend) which includes, at minimum, the principal amount, interest rate, maturity date, default provisions, repayment/amortization schedule and terms, possible collateral (in which case you’ll also need a security agreement and a UCC filing or a deed of trust), and dispute resolution terms. If the money is an investment (equity rather than debt), you’ll want to include the family member or relative as a shareholder or member of your corporation or LLC, and the rights and obligations of both the company and the equity investor must be spelled out in detail in the company’s constituent documents.  If you want to avoid problems both legal and personal, that is

  • Did you provide anything in writing describing your business and the expected return on an investment in your business (e.g., a business plan or a more sophisticated document, such as a Private Placement Memorandum)?

Bear in mind that even the smallest startup is bound by the antifraud provisions of federal and State securities laws with respect to the raising of equity capital, as opposed to debt financing. There are filings to make (such as a federal Form D and state Blue Sky filings), documents to deliver (such as subscription agreements, accredited investor questionnaires, and shareholder or operating agreements), and regulations to follow. Each investor must receive exactly the same information as each other investor, so if you delivered a business plan or PPM to any investor, you’ll need to deliver the exact same document to ALL potential investors. Running afoul of any of these requirements could result in serious problems for your business if you ever find yourself in the middle of a dispute with your investors.

It would also be very useful to prepare a set of pro forma financial projections demonstrating the expected return on an equity investment. This is not only useful for managing expectations, but it’s also important, from a legal perspective, that you disclose any and all material facts about your company and its prospects to your potential investors.

  • If the company goes belly-up (and lots of startups do), what are the rights of your lenders or investors? Remember, we’re talking about your friends and relatives here. Will they expect you to personally make good on their losses? Will they silently seethe and exclude you from all future family functions while badmouthing you within the business community? Are you sure you’ve discussed these issues with them and that your documents accurately reflect both your intentions and your investors’ or lenders’ expectations?
  • Suppose the company needs additional cash. Do you have a right to subordinate the loans of your family members to subsequent lenders (such as other family members)? Can you subordinate their Notes to a bank? (It would be a very good idea to retain this flexibility in case it’s ever necessary to utilize it.) Or, in the case of equity, do you have the ability to dilute the shares or equity interests you issued to your family members or friends by issuing additional equity to third parties?

These are just a few of the many issues you’ll need to consider as you raise money at the startup phase or for ongoing operating expenses. Which is why it bears repeating: if you’re going to be raising money from third parties (even if, or especially if, they’re relatives or friends), be sure you put the terms in writing. A very detailed writing. When all parties understand up front what their rights and obligations are, it’s much less likely that you’ll end up estranged from your family members down the road. Remember that you’re going to be married to your relatives and friends for an extended period of time via your mutual business interests in the company. There are rarely any divorces, and courts are not sympathetic to family issues in corporate disputes.

So, before you take money from the 3 F’s, ask yourself: Are you ready to get married? And is the necessity of financing the business worth the potential family issues that could arise down the road? If the answers are yes and yes, be sure you put the arrangements in writing at the outset, and be sure all parties sign that agreement before any money changes hands.