Q: Is it wise to seek financing from family members and friends? And how does this strategy fit in with my overall financing plan for my company as I start and grow my business?

A: The basic fact remains: Most emerging small businesses are launched with personal savings and other assets provided by the founding ownership team. The entrepreneur believes very strongly in the innovative idea, has a deep and abiding passion for accomplishing that objective, and embodies the vision for how this product or service will impact or change a market. These create significant incentives to invest personal resources to back the business that will execute the mission.

Decades of applied research have repeatedly shown that few, if any, new companies are ever started with formal venture capital or funding from commercial banks. The venture funds do not put money into completely untested and unproven concepts. They typically invest once the venture has demonstrated some initial results that simply need some financial backing to ramp up to critical mass. And commercial banks are by definition lenders, not investors. They provide lines of credit, transaction services and long-term collateralized loans for asset acquisitions.

The typical entrepreneur is faced with having to raise money in two general rounds. The second round might happen 18 months to two years after the company's inception. This is where the more formal venture capital is committed, and it happens after the company has already reached several significant operating milestones, including things like: a minimum revenue target, a baseline volume of units sold or contracts closed, a certain number of joint marketing deals, various successful tests of manufacturing capabilities, and securing exclusive sales agreements or product development rights and patents.

The first round (also known as the "A" round) is generally considered the time to raise capital from friends and family. It's interesting to note that these investors put their money in at perhaps the most risky point in the life of the venture. Unlike the subsequent--and more formal--"B" round, the firm probably has little or no revenue, few if any units sold or contracts signed, is probably still in the process of making any joint marketing deals, has yet to complete a successful test of its manufacturing infrastructure, and has not closed any sales agreements or been granted any product development rights or patents. These investors will say things like, "At this early stage, I'm not so much investing in the horse as I am in the jockey." They are backing the individual with the ideas, passion and vision to make this new enterprise a reality.

The friends and family round is critical in the life cycle of the new enterprise. At a time when few, if any, outside parties are ready to invest, sign contracts or enter into sales and marketing deals with a brand-new company that has no customers and no sales, family and close associates of the entrepreneur pool their financial resources and rally around the individual they've known for a long time and who they trust to "be smart with and spend wisely" the funds they provide. This "insider" round is further typified by smaller increments per investor, when compared to the second round of more formal "outside" capital. For example, it's fairly common to find the average investment per person to be between $5,000 and $20,000 in round "A", whereas in round "B", one company might underwrite the entire $500,000 to $1 million raised, or two companies might split a $1 million investment down the middle to share the risk exposure. The main thing to concentrate on is providing better and more attractive investment terms for your friends and family when compared to the formal investors, who come in maybe 18 months or two years later.

David Newton is a professor of entrepreneurial finance and head of the entrepreneurship program, which he founded in 1990, at Westmont College in Santa Barbara, California. The author of four books on both entrepreneurship and finance investments, David was formerly a contributing editor on growth capital for Industry Week Growing Companies magazine and has contributed to such publications as Entrepreneur, Your Money, Success, Red Herring, Business Week, Inc. and Solutions. He's also consulted to nearly 100 emerging, fast-growth entrepreneurial ventures since 1984.


The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.