When Kaaren Whitney-Vernon had an opportunity to buy Toronto specialty publisher Youth Culture seven years ago, she knew she would need financial help.
Ms. Whitney-Vernon sought and won the financial backing of a well-off family friend, who in turn brought in two similarly deep-pocketed investors to help her buy out the company’s owner and bankroll its operations in the early days. It was the start of an ultimately successful, though often nerve-wracking, arrangement that ended about a year ago when she bought out her minority partners and took sole ownership of the company that publishes magazines for teens and tweens.
“My investors were real investors,” she says. “Every quarter, you had to be showing growth, and the goal was in five years we sell the company,” she said. “There was that constant pressure because they are investors, that was what they gave the money for, so don’t get confused that they are friends. At the end of the day they are not. They are giving you money because they want something out of it.”
For her, the arrangement at least started as a convenient financial relationship, but for many budding entrepreneurs, tapping the financial resources of friends and family may be the only option to obtain early business capital as banks have tightened lending standards since the economic downturn.
“Banks are not going to give us money now, or in the future,” said Andrew Patricio, a small business consultant and partner of Toronto’s BizLaunch.com. “We believe that every small business now is going to have to bootstrap. If you are starting a business, it is probably going to be very, very difficult to raise finances.”
He sees just two places for most would-be entrepreneurs to go: family and friends, and wealthy “angel” investors. Much of his advice for pursuing cash from angels is also applicable for getting funding from friends and family.
First, don’t even bother without a bulletproof business plan. “Angel investors will say the business plan was the key reason that they invested in a company or the main reason,” Mr. Patricio said. “You have got to know your industry, you have got to know your numbers, you have got to know your marketing plan and you have got to know that these guys know their stuff.”
Attracting potential investors to put some cash on the table is one thing. The next challenge is figuring out just how much of the company to give up, for the capital that you need either to start the business or, in Ms. Whitney-Vernon’s case, to buy it from the existing owner.
“This is one of the biggest challenges small business owners have, which is how much do you give away?” said Mr. Patricio. “The answer is very simple: the least possible. Whereas the investor typically wants the most possible. Ideally you want to keep the major share, which is difficult. “
Ms. Whitney-Vernon, who already owned a small stake in the company, was able to retain a majority stake when she brought in the trio of investors. Her businessman husband, who consulted her on the deal, pushed her to take the titles of president and chief executive “to make it clear that ownership and everything else” was in her hands. But in the end, for her, negotiating majority ownership was the most important accomplishment of the private financing experience.
Toronto advertising executive Karen Howe knows all too well the downside of relinquishing financial control of a family business to an outside investor. She, her brother and mother sold majority control of their southern Ontario brewery a number of years ago to a family acquaintance to finance further growth.
“For us it was our undoing,” she said. “We chose the wrong partner and it was horrible.”
The new majority owner of the brewery, which Ms. Howe asked not be named, had the big pile of cash that her family wanted, but he didn’t have the time or the skill set required to manage major business decisions, a function she said he insisted on. “He became a bottleneck,” she said – all decisions beyond a certain cost had to be approved by him.
For Ms. Howe, the lessons are stark. “Really define the terms of your partnership clearly, and really make sure that you can’t do it on your own before you even look at a partnership. I would try to do anything to keep it self-financed if I could in hindsight.”
Tips on asking for seed money from family and friends
- Make sure you put it in writing, Mr. Patricio said. Put the loan principle, repayment terms and interest (if any) in black and white.
- What happens if you can’t repay? “That needs to be discussed right up front,” he said. “The most important thing with family is always to tell them that startups are very, very risky and there is a chance that you could lose everything.” Family and friends can often be overly optimistic, he added. “The biggest challenge is that people often focus on the positive,” the best-case scenario.
- Incorporation might be a solution. Selling family members shares of stock will not eliminate the startup risk, but it will make it clearer to them their risks and responsibilities. “That often solves most of the problems,” Mr. Patricio said. “That doesn’t mean that if you lose the money they will be happy, but they knew up front, ‘we were buying shares in a thing.’”