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Raising Cash Close to Home

You can raise startup funding from friends and family, but if you don't keep these tips in mind, prepare for heartache!

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Q: I am starting a new company and have invested $50,000 of my own , but I still need more money to get the going. What are some good funding sources for a start-up? What should I know before I ask family and friends to invest?

A: Many of the questions I've received this past month have asked about raising money for start-up companies. And the biggest item still seems to be the issue of raising capital for the launch. Several readers told me that they're ready to invest $15,000 to $50,000 of their own money. Some are putting in around $25,000, and their partner is investing another $25,000. But in almost all these inquiries, the entrepreneurs needed additional funds to get the business going, but were turned down for a bank loan.

I've written many articles about the role of commercial banks in start-up companies. Banks do not lend money to start-ups, plain and simple. Banks lend money to businesses with an established track record of clearly identifiable cash flow (monthly revenues, cost of goods sold and overhead expenses), as well as businesses that have the capacity to pay back the principal and interest on the loan. They do not "invest" in start-ups, and they don't make loans unless there is collateral to pledge and cash flow to service the .

For more than 30 years, applied research in has shown time and time again that upwards of 90 to 95 percent of start-up companies in the United States are funded by three main sources of capital: 1) the entrepreneur's own funds, 2) funds from friends and 3) funds from family. However, the "friends and family" (FF) round of capital is typically one of the hardest series of transactions for a start-up to manage.

First, when friends and family members co-fund an entrepreneur's start-up venture, they are either approached about investing or they offer to invest. Obviously, the former situation requires more care when navigating the process, because the entrepreneur has to pitch the friend or family member on the merits of the company in a particular market. In the latter situation, the friend or family member wants "in" and asks to get a stake in the company. In either case, the key is to be sure you have a written contract with an letter that clearly outlines who approached who about the funds in question and explains the specific terms of the funding.

The funding will either be a loan or an ownership stake. The debt vs. equity question is also very common and has been around forever. If the friend or family member wants to be a creditor to the entrepreneur's firm, write a promissory note that explains the repayment of the principal and the way interest will be calculated and repaid on the loan, including the timing of all such debt service. If the capital coming in will be equity, be sure to designate whether the funds are voting shares of common stock, non-voting common shares or preferred stock. The key here is to decide what the company's value is and then assign a fair and agreeable percentage stake to the new funds based on what they represent in value to the overall venture.

So whether it's debt or equity, get it all in writing and negotiate everything so there are fair terms on the front end and no basis for complaints or discrepancies on the back end. After all, a few years from now, your business's prospects and results will have changed either positively or negatively from the day you received the FF capital.

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 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.

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