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.
Content Continues Below
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.