Start-ups typically have limited access to external funds to support getting their business off the ground. Formalised channels that established businesses can access are often not available.
Banks and investors typically want to manage their risk and prefer a business with prior history of performance that they can use to evaluate their return on investment. Most start-ups obviously can’t provide this track record.
As a result, many first time business owners self-fund and seek the support of the three “Fs” – family, friends and fools – to obtain the initial cash they need to start their business. While this can seem an attractive and easily accessible source of cash, it’s one that if not managed properly can be fraught with danger.
Consider the pros and cons:
Existing relationships make for easy convincing
Family and friends know and trust you, so are more willing to lend you the cash you need. Their history with you means they believe you’ll try hard and make the business a success and, because of this, they think their investment in you is a good one.
No admin or red tape
Banks and professional investors want information and forms filled out before they will give you the cash. Providing this detail can be a time-consuming task and involves lots of thought and consideration. There are legal documents and contracts to read, understand and commit to. Starting up a business is very time consuming and stressful by nature, so avoiding this red tape and all the questions that come with it is an attractive proposition.
Flexible payment terms
Friends and family are often more willing to wait before you start returning their money. This means you have the time to start making sales, taking payment and maybe even earning a wage, before you have to repay that cash.
Low or no interest
It’s also a cheaper source of cash. Family and friends are typically willing to give you a good deal, in the faith that they’ll get their money back or even multiplied. This is great as there’s limited additional dollar cost involved in obtaining and using their cash.
Unsolicited advice and involvement
Having invested their money in your business, friends and family might see themselves as a part owner of the business. They may believe they have a right to influence how you run the business, voice their opinions about strategic decisions or determine how you use the profits you earn. They may not understand the realities of business or get upset when you don’t follow their advice.
Lack of clarity
If there’s no documented agreement, there’s a risk you have a different understanding of the terms of the loan or investment your family and friends have made. Even if you’ve had a detailed discussion at the outset, memories fade and changes in circumstances can influence expectations over time.
Potential to burn bridges
You need to consider the risk you are committing your family and friends to, when they invest in your business. If the business fails, how will you get their cash back to them? What if they’re using their emergency nest egg or savings for a planned future event they’ve always dreamed of?
Are they borrowing against their house or other assets to give you the cash? You need to consider what will happen to them, as well as your business, if you don’t have the cash when it’s needed. If you fail, there’s a possibility that you’ll burn your bridges and then have no one to turn to for support.
Lack of initial assessment
Friends and family are typically naïve investors; don’t understand the realities of business or what the business ownership journey is like. On the other hand, banks and professional investors have more knowledge and experience they can use to put their investments through a rigorous evaluation process.
While this might seem like jumping hoops to new business owners, there’s a lot of learning and benefit first timers can take from this. It will help them determine whether their idea actually is a good, commercial business idea that should even proceed at all. If so, you’ll develop a more robust business value proposition and go to market strategy, as well as understand and address the potential risks.
Lack of accountability
Banks and professional investors provide ongoing accountability. They expect the business owner to keep them informed of their progress and might require you meet certain targets over time, as a condition of their loan or investment. Having a third party who is focused on business performance and outcomes is a good thing, not only for them but the business owner as well.
Here are my top five tips if you decide to go ahead with family and friends as investors:
1. Test your idea and put it through rigorous evaluation
Every new business idea should be put through proper testing and evaluation. You can do some of this yourself, but should also seek the feedback and input of trusted advisors and mentors familiar with business. For more information read my previous blogs about low risk planning for start-ups and how to stress test your business idea.
2. Acknowledge all the risks
Putting your business idea through rigorous testing and evaluation will highlight the potential risks for your business. Be upfront and honest with yourself and your investors about them. Given family and friends are typically naïve investors, they will see the upside but not the pitfalls of their investment. It’s your job to be completely honest in your pitch to them and make them aware of the possible failure of the business and loss of their cash. Find out what their expectations are in that scenario and then manage those expectations and devise a plan to address their needs.
3. Have a contingency plan to pay them back
To do the right thing by your investors and prevent permanently complicated personal relationships, you should consider the worse-case scenario and have a plan to deal with it. This includes a realistic plan for how and when you’re going to repay any cash your family and friends have given to you.
4. Formalise things with an agreement
It’s important that you formalise your arrangement with family and friends with an agreement. This agreement should be similar to what you would enter into with a professional investor or lender. I’ll be covering this issue in a future blog post.
5. Get professional advice and recommend your family and friends seek their own
It’s important you seek professional legal, tax and financial planning advice when establishing your business. For most business owners it’s their biggest investment and they expect it to meet their wealth and retirement needs.
Your family and friends should also obtain their own independent legal advice to help them understand any agreements or contracts they are entering into, whether they are written or verbal. They should also obtain tax and financial planning advice to understand the personal tax and financial implications of their loan or investment decision.
Being fully away of your obligations and the repercussions of your decisions means you can both make fully informed choices.
Marc Peskett is a Director of MPR Group a Melbourne based business that specialises in providing, business advisory, tax, grants and funding services and outsourced accounting to small and medium enterprises.
MPR Group are holding a full day workshop on 21 June to help business owners including start-ups, develop their annual business plans and budgets. To register click here.
You can follow Marc on Twitter @mpeskett