3 Steps to Make Friends-and-Family Financing Work

Raising capital for your new business can be extremely hard. Even if you have a billion dollar idea, most likely you won't be able to raise funds from outside investors who don't know you when you don't have much to show for your company. After all, 8 out of 10 entrepreneurs who start businesses fail within the first 5 years.

One viable early stage funding option is to get investments from your friends and family. In fact, more first-time business owners borrow from their friends and family than from banks nowadays. It's great to have your close ones support your new venture but it's important to not destroy your relationship in the process. The following is a step-by-step guide for getting funding from your friends and family:

1. Manage their expectations. When your friends and family invest in your company, you want to make sure you understand their motivation and financial means. Do they just want to help out? Do they think it's a good business idea and they want to be a part of it? What happens if the business fails? How do they expect to be paid back? Clear communication up-front can minimize emotional distress in the future. If your mother is giving her life savings to your new venture, how is she going to support herself should the business fail? If your brother loans his downpayment to your business, how can he get the money back when he finds the right home to buy? These are scenarios you should think through when you are getting investments from friends and family.

2. Make it formal and put it on paper. Once you make the decision to take investments from your friends and family, you want to make sure you have formal agreements in place. If the investment is structured as equity, you can use the various open sourced legal documents like this or this to execute the deal. Some people like to hire a lawyer to make sure things are done properly, but lawyers can be expensive. If your company is still really early-stage, we recommend you use the template legal docs as mentioned above as a first step. You can always rectify the documents later when your business is much more developed.

If the investment is structured like a business loan, we highly recommend you use services like LendingKarma, LoanBack or National Family Mortgage to formalize the agreement, streamline the payments, and make the tax returns simple. National Family Mortgage's agreement actually puts a lien on your house. In the case that your loan defaults or you pass away suddenly, your friends' and family's investment in your business would be protected. Using services like these make you more accountable and really sets expectations (and boundaries) between you and your friends and family. We highly recommend you use one of these services to minimize the potential distress from a friends-and-family loan.

3. Communicate and share your success. Once the money is in the bank, make sure you communicate your progress regularly to your investors. They are the people who believe in you and would appreciate your updates on how you're using their money to make the business work. Even if your business fails, frequent updates might make them more forgiving and you can work out a long-term plan to pay them back. If your business turns out to be very successful, don't forget to share your success with them. Send them product samples. Thank them in public. Buy back their shares with a much higher price. Of course your talent and hard work is how you make the business succeed, but without your F&F's capital and trust, it will be much, much harder. Bottom line: be grateful.

Starting up a business is hard. If you are fortunate enough to get financial support from your friends and family, make sure you manage their expectations well and keep good relationships with them no matter how your business turns out.

Read more about how to obtain business financing for your business at Fundastic.