It has never been easy to raise capital for your small business, especially if you are in the start-up phase. If you can't finance your business out of your own pocket, by maxing out your credit cards or taking out a second (or third or fourth) mortgage on your home, you'll have to seek funding from the people who know and love you. That means approaching the "three Fs"--family, friends and fools--for the funds.

First, the good news: Friends and family members are more willing to invest in you because they love you. They are less likely to scrutinize every comma and semicolon in your business plan, or to demand a high return on their investment.

Now the bad news. Raising money from friends and family creates personal and emotional issues that go beyond business judgment. If you borrow $10,000 from your Aunt Irma and fail to pay it back, you will have to see Aunt Irma at every Thanksgiving dinner until she dies. Even if she is the forgiving sort, she will no doubt remind you about how you blew her casino funds, and may be tempted, especially after the second glass of white zinfandel, to tell the whole family about it, over and over and over again.

Aside from personal embarrassment, there are some real risks in taking money from friends and family. Friends and family members will inevitably say they are "giving" you money for your business, but rarely do they mean to make you an outright gift in the legal sense. Because friend/family investments are usually made in a very informal way, misunderstandings can occur about precisely what the friend or family member expects in return for their money. You may think it is a loan, which you will repay in time with interest. Your friend or family member, on the other hand, may think of it as an investment for which they will receive stock or an ownership interest in your business. That initial confusion may have bad legal consequences down the road.

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Before you accept financing from loved ones, heed these warnings.

Also, sad to say, money changes a lot of people, and not necessarily for the best. People who honestly intend to "give" you money when you are just getting started may be tempted later on to think they are entitled to a return on their "investment" when your hot new product hits the market and you are rolling in dough.

Even if your friend or family member doesn't change his or her mind about their gift, you can't be sure other people will see it the same way. If Aunt Irma "gives" you $10,000 and then dies the following month, you are no longer dealing with your loving Aunt Irma. You are now dealing with the executor of Aunt Irma's estate, who may be 1) a greedy relative who sees the "gift" as an investment for which the estate is entitled to a substantial piece of your business, 2) a local estate lawyer whose main purpose in life is to squeeze as many assets out of the estate as possible so as to maximize their fees, or 3) someone even worse.

When seeking money from friends and family, it's important to be as disciplined as you would be in dealing with a professional investor. Here are some basic rules:

  1. Treat them as if they were strangers. Forget for the moment that your investor is a friend or family member. Make it an "arm's length" transaction, and insist on the same sort of legal documentation you would prepare if your investor was a total stranger. If it's a loan, have your lawyer prepare an I.O.U. (called a "promissory note") for the friend or family member, and don't offer less than a "commercial" interest rate (currently 6 to 8 percent).
  2. Debt may actually be better than equity. If someone "lends" you money, you only have to pay it back, with interest. They can't tell you how to run your company. If someone buys stock in your business, they are legally your business partner. When in doubt, make it a loan, and pay it back as soon as you can.
  3. Tie all payments to your cash flow. Try to avoid obligations with fixed repayment schedules. Consider instead "cash flow" obligations, in which your investor will receive a percentage of your operating cash flow (if any) until they either have been repaid in full with interest, or have achieved a specified percentage return on their investment.
  4. Consider nonvoting stock. If your friend or family member insists on buying stock in your company, try to make it nonvoting stock, so they don't have the right to second-guess your every management decision.

Cliff Ennico is host of the PBS television series MoneyHunt and a leading expert on managing growing companies. His advice for small businesses regularly appears on the "Protecting Your Business" channel on the Small Business Television Network at www.sbtv.com. E-mail him at cennico@legalcareer.com.