Most startups and growing businesses will need access to outside sources of financing to be successful. The funds are often needed for capital investments such as equipment or vehicles, or for working capital to finance inventory, sales and marketing expenses, or to cover losses in the early or tough years.
While there are many sources available to fund these types of cash-flow needs, borrowing from friends and family is frequently suggested. While this may seem like an easy and appropriate route, it has its drawbacks and all parties should tread carefully before turning a friendship or a bloodline relationship into a business one.
Friends and family money in the form of a loan or an equity investment – selling a piece of your business through a share offering – instantly creates a formal business relationship, almost like a partnership, with a person or people with whom you share a close personal relationship. Maybe you grew up with them, partied with them, or saw them regularly at social fucntions. Once you allow that relationship to include money, it creates a new dynamic that might not always be positive.
First, friends and family money for your small business is likely not coming from sophisticated and experienced lenders or business professionals. They are typically people who invest because they want to support you financially, but their enthusiasam comes from an emotional place, not an objective business investment case.
Second, friends and family often do not understand the dynamics of a business, let alone the unique aspects of yours. They can be supportive and enthusiastic at the start and when things are going well, but they can be a challenging burden if the investment or repayment plan gets sidetracked or delayed.
Lastly, if things get complicated in your repayment or growth schedule, the friends and family that supported you are now looking at you with disappointment and intense pressure to set things right. What was once a powerful personal friend or family member can now be an uptight and frustrated business partner. Most people in these situations cannot separate the two aspects of your relationship with them and things get strained.
I have seen and heard stories of siblings and best friends whose relationships were permanently ruined by a friends and family business financing deal that went bad. These relationships often don't recover if money is lost in the deal and it often permeates into the larger circle of friends that once existed or a larger sphere of family members than just the ones directly involved in the original transaction.
If there is so much downside to turning to friends and family to help finance small businesses, why is it so popular? Many small businesses, especially in the early years, are not attractive to banks or other more traditional sources of financing. That is a shame, because the formalities of dealing with a bank – submitting and presenting a formal business plan, sharing monthly, quarterly and annual financials, creating yearly budgets and projections – are good exercises for entrepreneurs as it holds them to higher standards of communications and reporting. In the absence of traditional financing, friends and family may seem like the only viable alternative.
My suggestion is to look beyond friends and family, to other small or medium-sized business owners in your network, and to hunt down angel investors or investors in the networks in your industry or geographic area. Angels are usually successful entrepreneurs who have enough cash of their own to be interested in diversifying by making loans or equity investments in a business like yours.
I like angels because they have experience making small investments, and since they don't have a direct personal relationship with you, they will be critical, challenging and objective in their analysis of your business opportunity. And besides just contributing cash, these angels likely have experience to share with you in the form of advice and guidance and a powerful personal and professional network to help your business succeed.
If you have friends and family with enough money to help you, they can probably introduce you to other people in their networks, and that at least keeps it another personal level removed, more objective and more business oriented than emotional. You can also ask your local banks, chambers of commerce, and other businesses about who might be interested in talking.
Friends and family money is tempting, I get it. If I had done so in my businesses, I would have saved a lot of time, to be sure. But the downside was too much for me.
I didn't want the potential strain on my personal relationships, and most importantly, I benefited from stepping up my business planning, investor pitches and reporting by dealing with more sophisctated business people and investors, even though the deals were often quite small. All of that was good for business and my relationships are intact – emotional support and encouragement from friends and family over the years has been worth more than money could by.
Keep your financing simple and keep it separate from friends and family.
Chris Griffiths is the Toronto-based director of fine tune consulting, a boutique management consulting practice. Over the past 20 years, he has started or acquired and exited seven businesses.