The issues of business funding from family members

Sometimes the best source of funding is through family and friends, but this can be fraught with delicate issues. Funding expert, Julian Smith wades into the personal loan waters.

According to recent research by Everline, of the 1,000 small businesses surveyed, 10% gained access to cash through friends and family.

Whether for short term financing needs, or the early stages of pre-seed equity investment, access to funds from friends and family remains an important source. There are many advantages to this, but these arrangements should be entered into with eyes wide open.

For the entrepreneur, the benefits include relative speed, flexibility, and absence of bureaucracy. With so many other priorities and demands when trying to get the business off the ground, there is a real upside in not getting distracted with a lengthy fund raising and diligence process.

Also, there’s something to be said for the entrepreneur who can demonstrate the appeal in order to secure early-stage funding from friends of family. Or, put another way, if the entrepreneur couldn’t persuade those closest to them to back their business idea, then how could they ever convince a professional investor? However, there are downsides.

Statistically, 72% of new businesses fail within the first five years. One of the benefits of angel investment is to benefit from the knowledge, network, and counsel of the angel investors, which is unlikely to be achieved through inexperienced friends and family investors.

Taking the above into account, here are three simple points to consider to guide better decision making if you go down the route of family and friends investment:

1. Look for well connected friends and family

Think about the networks and experiences that might be available to you through this new contractual relationship. Any investor will want to help make the business a success, so try to partner with those who have the most to contribute.

2. Target those who can afford to lose it

Statistically, failure remains the most likely outcome. Therefore you should approach people who understand the risks, and can afford to lose their investment. If not prepared for this eventuality, you could see your personal relationship deteriorate rapidly at the point you need support most.

3. Keep it simple and documented

In terms of structure, there is no need at an early stage to start adopting the kinds of terms that you would see in a VC deal, but at the same time there’s value in finding a friendly lawyer to document the terms of the deal. This will avoid the risk of misunderstandings later on.

One approach often used is to structure a convertible loan that converts into equity, at a modest discount to the valuation agreed at the next funding round. It avoids a valuation discussion at this early stage, and provides some preference over founder capital.

Like any decision, you should only choose to go down this path after considering the alternatives. And if you do, you should do your best to avoid the ‘fools’ who are frequently bracketed with the family and friends in the ‘three F’s’.