When a family member invested in her business last year, Leah Eichler spent three days walking around with the cheque in her purse before she could bring herself to bank it.
“I had to come to the realization that I am as good as they think I am,” said Ms. Eichler, a Globe and Mail columnist and creator of Femme-O-Nomics, a digital networking tool for professional women. “And when I realized that I wasn’t going to fail them, I was comfortable taking their money.”
Ms. Eichler’s cautious attitude is a wise one, experts say.
Most entrepreneurs feel tremendous responsibility to people who invest money in their dreams, and that’s amplified when it’s friends and family.
“It’s an incredible amount of pressure,” said Patrick Keefe, vice-president of investment at Halifax-based Innovacorp.
A lot of Canadians nurturing new businesses are feeling that pressure. When it comes to informal-source financing for start-ups, venture capital from family and friends is key. It accounts for 80 per cent of the $10-billion invested in them annually, says Allan Riding, Deloitte professor at the University of Ottawa’s Telfer School of Management.
Indeed, Toronto has become “the best living lab there is in North America” on how to grow family-financed innovation-based businesses, said lawyer Suzanne Dingwall Williams of Toronto’s Venture Law Associates LLP. With a dearth of venture capital and many young MBA grads striking out on their own because of the lack of jobs, “the major engine driving the Toronto scene for the last few years has been friends and family money,” she said.
The fact that it is common practice, however, doesn’t make dealing with this type of financing any less challenging. So-called “love money” may come without the demands and conditions imposed by banks and other institutional investors, yet is potentially even more fraught. While you won’t be passing the turkey to your banker at Christmas dinner, you can’t avoid that family member who invested in your business.
“It’s a burden,” Mr. Riding said. “You’re responsible for their money, and they see you as responsible for their money.”
There are a number of matters to consider when accepting financing from loved ones.
In certain types of business, where the financing is one-shot and cash flows are fairly immediate, there are fewer ways for things to go wrong, Mr. Keefe said. In these cases, it needs to be clear ahead of time whether it is the company or the individual who is liable, he said.
But things can get sticky when the venture is based on a new idea or innovation. “Where you have significant capital expenditure before you break even, often measured in years and millions of dollars, the entrepreneur needs to be mindful and careful,” he said.
To keep debt off the balance sheet, this investment will most likely garner the friend or family member some equity. It is when the company needs a fresh round of financing that, as Mr. Keefe put it, “love money can be treated poorly.”
If a big institutional investor comes in but places a lower value on the company, the entrepreneur is in a difficult position. “They need to raise money to keep the company alive,” he pointed out, “but they’re conflicted because they know it means a family member’s equity is going to get diluted.”
What’s more, he said, “institutional money [often] comes in as a preferred share, with sets of rights and privileges separate from the common shares. So friends and family are behind in certain preferences, like liquidation preferences and protective provisions.”
Almost half of new small businesses do, in fact, fail within five years, according to Industry Canada. For Mr. Riding, therefore, “the key thing is that everybody has to go into this understanding that losing the investment is often going to happen.”
Even when a business venture does succeed, the potential for conflict doesn’t necessarily disappear. “You might get your money back, and you might get interest on it,” theorized Mr. Riding, “but people can look at it and say, ‘If not for me, this wouldn’t exist. Maybe I didn’t get my fair share.’”
Another potential land mine? The tendency of ‘Uncle Joe” or your best friend to feel that their investment has also bought them a say in how the business is run.
In her experience, informal financing worked best, said Ms. Dingwall Williams, “when there was a terrifically thought-out business plan. People didn’t aim too high. They had an idea for a business that might become really big, but at a minimum they knew how to make it profitable, and could start to repay the money they were advanced.”
This removed much of the risk, she said, “and brought in friends and family who understood when they would probably get paid back even though there were no guarantees.”
By envisioning the process over time, entrepreneurs can prepare loved ones for what is really in front of them. And that needs to be written up in watertight language. “The main thing I preach is transparency and clarity,” Mr. Riding said, “that whatever the agreement, it’s really crystal clear what happens with the various possible outcomes.”
An admitted “stickler for getting things down on paper correctly,” Ms. Eichler said that, in her case, “it’s very clear for all of us involved where we stand and what our obligations are. So it lets me sleep easier at night.”
After all, she added, “these are people who are very important to me. You never want to let yourself down, but you definitely don’t want to let your friends and family down.”