Gut Check: Should You Accept Startup Money From Friends & Family?
In an Entrepreneur Magazine article “Why Friends and Family are Your Worst Business Enemies,” CPA and attorney Mark J. Kohler advises, “…I typically recommend my clients not invest with close friends and family.” Entrepreneur Michael Hess’ article in CBS Money Watch entitled “5 Dangers of Doing Business With Family and Friends” offers good reasons to avoid it as well: “The business comes to the family picnic,” or, “There’s collateral damage.”
I won’t refute this advice. Yes, founders should ideally avoid raising money from friends and family (f&f), but starting a company is rarely an idealistic journey. Raising money to start a company is insanely challenging. Plenty of successful founders I’ve interviewed raised cash from f&f to get started. Moreover, what if f&f are your only viable funding option? What if your f&f have offered to invest, and it feels ok? Is it ok then?
That choice is up to you. I’ve made four f&f investments myself, one with my family and three with friends. I’ve interviewed dozens of successful founders who have raised money from f&f. If you decide to go for it and ask your f&f network to literally buy into your startup, here are some tips and best practices:
- The best investment type is “love money”: Bob Young used love money to launch $1.8 billion Red Hat Software and describes it this way: “Love money is precisely what it says, which is that people are investing in your business, not because they know anything about your business, or because they think you’re clever; they’re investing because they love you.” By accepting “love money,” you have to treat it like receiving a gift because they aren’t betting on you or your proposed business — but instead they’re hoping you’ll succeed because they love you. There’s absolutely nothing wrong with taking love money if you follow these other tips and best practices as well.
- Mention the investment request upfront: Never request a meeting with a friend or family member in order “tell them” about your business idea, and then at the meeting, ask that they invest. It puts them in an uncomfortable spot. Instead, I recommend communicating something like this: “Hi Friend/Family: I’m starting a new company and raising money. I would rather have a great friend/family than an investment, so please feel no pressure. Would you be willing to meet with me to learn more about it? If you’d rather not get involved in my business ventures — I’d totally understand.”
- Invest a majority of your own money first: Make sure you tell friends and family members how much of your own money and sweat equity you’re investing. Also, make sure they know that their investment isn’t paying your salary. Take a night job before you accept f&f dollars to pay your salary during startup.
- Never accept large amounts from f&f: Professional golfer Michelle Wie once told ESPN, “If someone wants to give you, like, $100 million, it’s hard to say no. But I don’t want to accept that kind of money right now. I’d feel burdened by it.” Michelle’s sentiment is quite wise — you don’t want the pressure of having to return investment money to those you love. The perfect f&f investment amount could be landing $15,000 from five relatively financially well-off individuals, $75,000 total. Each would invest with the caveat that the money can easily be gone forever, and without any ramifications that would impact their savings, retirement, or spending in any significant manner. You don’t want f&f to feel their potential investment loss is a financial hardship.
- Decide upfront about “follow on” investing: The trouble with f&f startup investing is that rarely is the first round of investment enough. No seriously — like almost everyone predicts they’ll need, for example $75,000 to start but then wind up needing $200,000. Who do founders beg from when they run out? The initial investors. I actually believe that deciding upfront about how to handle the next round is more important than avoiding f&f investing. For most situations, I recommend you decide upfront that you won’t come back to f&f looking for more money because if you do, their “love money” may easily evolve into something other than love (resentment or frustration, to name a few).
- Give f&f a fair deal: If you’re selling f&f shares in your business, give them a fair deal without them having to negotiate with you. In other words, don’t value your “idea” at a huge premium. Instead, keep your valuation realistic based on the amount of time and money you’re investing. Sure, your idea is worth something, but probably not $3 million! Also, ask a qualified corporate attorney to protect their interests by way of a shareholder agreement — and always make sure you have one in place before accepting f&f funds so there’s an understanding of how the business’ governance works.
- Keep f&f off your board of directors: Make sure f&f don’t join your board because that could put them in the awkward position of taking sides or, in a worst case scenario, having to vote to fire you. Better to make the only “business” you do with them be accepting the money, and having conversations about your journey over coffee, lunch, or dinner.
The most important tip is to trust your gut. Before ever mentioning to a friend or family member a potential startup investment, you’ll probably instinctively know whether or not it’s a good idea or not. Trust that judgment before any of my or anyone else’s advice. But starting a business is tough — so never completely nix any funding strategy.