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 $50,000of my own money, but I still need more money to get the businessgoing. What are some good funding sources for a start-up? Whatshould I know before I ask family and friends to invest?
A: Many of the questions I've received this pastmonth have asked about raising money for start-up companies. Andthe biggest item still seems to be the issue of raising capital forthe launch. Several readers told me that they're ready toinvest $15,000 to $50,000 of their own money. Some are putting inaround $25,000, and their partner is investing another $25,000. Butin almost all these inquiries, the entrepreneurs needed additionalfunds to get the business going, but were turned down for a bankloan.
I've written many articles about the role of commercialbanks in start-up companies. Banks do not lend money to start-ups,plain and simple. Banks lend money to businesses with anestablished track record of clearly identifiable cash flow (monthlyrevenues, cost of goods sold and overhead expenses), as well asbusinesses that have the capacity to pay back the principal andinterest on the loan. They do not "invest" in start-ups,and they don't make loans unless there is collateral to pledgeand cash flow to service the debt.
For more than 30 years, applied research in entrepreneurship hasshown time and time again that upwards of 90 to 95 percent ofstart-up companies in the United States are funded by three mainsources of capital: 1) the entrepreneur's own funds, 2) fundsfrom friends and 3) funds from family. However, the "friendsand family" (FF) round of capital is typically one of thehardest series of transactions for a start-up to manage.
First, when friends and family members co-fund anentrepreneur's start-up venture, they are either approachedabout investing or they offer to invest. Obviously, the formersituation requires more care when navigating the process, becausethe entrepreneur has to pitch the friend or family member on themerits of the company in a particular market. In the lattersituation, the friend or family member wants "in" andasks to get a stake in the company. In either case, the key is tobe sure you have a written contract with an investment letter thatclearly outlines who approached who about the funds in question andexplains the specific terms of the funding.
The funding will either be a loan or an ownership stake. Thedebt vs. equity question is also very common and has been aroundforever. If the friend or family member wants to be a creditor tothe entrepreneur's firm, write a promissory note that explainsthe repayment of the principal and the way interest will becalculated and repaid on the loan, including the timing of all suchdebt service. If the capital coming in will be equity, be sure todesignate whether the funds are voting shares of common stock,non-voting common shares or preferred stock. The key here is todecide what the company's value is and then assign a fair andagreeable percentage stake to the new funds based on what theyrepresent in value to the overall venture.
So whether it's debt or equity, get it all in writing andnegotiate everything so there are fair terms on the front end andno basis for complaints or discrepancies on the back end. Afterall, a few years from now, your business's prospects andresults will have changed either positively or negatively from theday you received the FF capital.
David Newton is a professor of entrepreneurial finance andhead of the entrepreneurship program, which he founded in 1990, atWestmont College in Santa Barbara, California. The author of fourbooks on both entrepreneurship and finance investments, David wasformerly a contributing editor on growth capital for IndustryWeek Growing Companies magazine and has contributed to suchpublications as Entrepreneur, Your Money,Success, Red Herring, Business Week, Inc.and Solutions. He's also consulted to nearly 100emerging, 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 innature, without regard to specific geographical areas orcircumstances, and should only be relied upon after consulting anappropriate expert, such as an attorney or accountant.