Editor's Note: Learn from a panel of experts and entrepreneurs who have successfully financed their own ventures and are helping others do it at the Thought Leaders Live 2013 event May 29, in Long Beach, Calif. Event and ticket information can be found here.
Friends and family remain the best shot that many entrepreneurs have to raise outside money to launch a business.
In 2010, 5% of U.S. adults polled said they had provided funding to someone starting a business in the past three years, according to a survey by the Global Entrepreneurship Monitor, a research consortium which includes Babson College. Of those respondents, 32% said the funding went to a friend or neighbor, 26% to a close family member, 11% to some other relative and 8% to a work colleague.
While preserving important personal relationships with people who fund your business can be a daunting prospect, clearly some entrepreneurs have figured it out. If you're thinking about asking friends and family for seed money, here are five tips for doing it right.
1. Choose a strategy.
Do you want to solicit large chunks of money from a few investors, or small amounts from many?
There's less pressure associated with small sums. "You're less likely to ruin a relationship over $25," says Cornelius McNab, founder of Atlanta-based 40billion.com, which facilitates friends-and-family loans and gifts. Most of the site's fundraisers target a few dozen people for sums between $100 and $500 apiece.
But typically only 10% to 20% percent people asked will contribute. So if you want to raise, say, $5,000 at $100 per backer, you'll need to woo 50 people. This means reaching out to 250 to 500 people.
Contacting a smaller, more targeted group for larger sums may require more gumption and planning upfront, it could be easier for the time-strapped.
San Francisco entrepreneur James Lee raised more than $1 million from friends and relatives in 2008 for his venture sale.com. He sat down to casual meetings, often over coffee, with 15 people and persuaded 10.
2. Choose an investment type.
When you accept money from others, strings will be attached, no matter how you structure the transaction.
Consider whether you want to accept and pay back loans, have your friends and family own an equity stake, or offer up a token of thanks -- say, some amount of free access to your product or service in exchange for a gift.
If you take on investors, you may have to give up a portion of your company, and perhaps make one or more board members. Even friends and family will want a return, which can mean eventually selling the company, buying back shares or paying dividends.
Loans have to be paid back on schedule, which can have an impact on cash flow and profitability. If you go the microfunding route, you could be juggling 50 of them.
Even gifts aren't free of strings. If you do accept them, thank the giver profusely in writing and acknowledge that the money is a gift rather than an investment or promissory note, says Denise Beeson, who teaches small-business management at Santa Rosa Junior College in California. "Just think if you gave Bill Gates some start-up funds. Would you want, after the fact, a return on your money? You bet," she says.
3. Write down your pitch.
Unless your friends and family are professional investors, they probably don't want to read a 50-page business plan. More likely, they'll prefer to sit down with you over coffee and hear you explain your idea, as Lee did.
Lee says that because his backers were people who knew him well and "were essentially investing in me," they didn't require a business plan.
To avoid being too informal, McNab suggests drawing up a five- to 10-page document that sums up what you want to do, how you'll do it and what you'll apply the money toward. Such a summary ensures you've made important disclosures, such as the key challenges, risks and competition the business faces, and that your backers understand what their money is going toward.
4. Keep your documents and communications business-like.
When you're dealing with people you know well, it's easy to want to keep agreements informal out of concern that official documents might make things feel less friendly. But don't be too casual.
If you don't want to involve a lawyer (but if equity is involved, you should), you may want to consider trying websites such as 40billion, Caplinked or LendingKarma that can help you structure, document and manage investments from friends and family.
5. Manage expectations.
Another upside of bringing in friends and family is that they are typically more patient than professional investors. "When we failed at plan A and at plan B, these people weren't looking for our heads," Lee says.
It's a good idea to send a monthly email update to your backers, even if they've given money as a gift, says McNab. Lee, for example, makes a point of reaching out to all of his backers informally about once a month by email, phone or get-togethers.
Be honest about what's going well and what could be better. You might want to raise more money later, and it can be easier if your backers have been able to watch your progress. "I've seen people ask for and get more from their backers in later rounds," McNab says.
If things aren't going well, friends who have a stake in your success are more likely than others to provide the advice, contacts or referrals you need to turn things around. Says McNab, "These are the people who will try to help you if they can."