What it is:
It is one of the most common forms of start-up funding out there. Banks and independent investors might not want to risk money on you. But those who are close to you and believe in you might be willing to take a chance on your fledgling business.
Upside: This is your best chance to secure money to get the business off the ground. If your friends and relatives don’t want to give you money, who will? If one or a few of them has business savvy, better yet. Bringing them on as investors transforms them into motivated advisors. Plus, they will likely be more forgiving than outside investors when it comes to your business’ ups and downs.
Raising money from your personal network can also be a step toward securing money from future investors, because it demonstrates that you are grounded in a network of family and acquaintances who have already bought into the business plan.
Downside: You risk lost friends and strained relationships with relatives. Your next holiday party won’t be as fun if half the people there think you fleeced them on a failed business venture, or are annoyed because you went on vacation before paying their money back.
That is why it is best not to get too informal about the business relationship. Be upfront about risks, lay out the business plan that the money will fund, and put the rules behind the investment in writing.
How it works: It could be a gift, a loan or an equity investment in the business. Each has pluses and minuses, and each should be recorded in writing, in many cases a legal document.
The investment can take various forms
Gifts: The great thing about a gift is that you don’t have to pay it back. But you probably won’t raise as much as you would if you were offering a potential return on the money. Also, gifts can quickly turn into loans in the minds of friends and relatives should you succeed. A signed document, even a letter saying the money was given, will protect you down the road.
Loans: Many experts suggest loans as the optimal way for friends and family to invest because there are set repayment terms. They will know how long it will take for them to get their money back and at what interest. (If you are current with repayments, you also can avoid drawing their ire should you spend money on yourself.)
A business attorney can easily draw up a “promissory note” detailing the terms of the loan. An SBA Community entry suggests another strategy to formalise the relationship: structuring the loan through a peer-to-peer (P2P) lending company that will act as an intermediary, collecting the payments from you for a fee.
The downside of borrowing is that you are tying up some of your business’ cash flow in the repayments.
Equity: You don’t have to pay them until you make a profit or cash out, but you are literally turning a friend or a relative into a business partner if you give them an ownership stake in the company. You will want a business lawyer involved in this.
Consider if you want this person as a business partner? He or she will have a right to tell you how to run the venture. This can be highly beneficial if your acquaintance/investor has entrepreneurial experience or other useful know-how. But it can quickly become an annoyance otherwise. You also risk straining the relationship should you move on to another venture.
How to get it: It is always advisable to present a formal business plan when pitching to prospective investors – even friends and relatives. But unlike in other cases, you don’t need to present printed materials and charts up front. Rather, it is best to lay out your business plans verbally, because those in your personal network will likely base their decision on trust.
The “kitchen table pitch” is really about selling yourself. Be frank about the risks, and explain what the money will go toward and how it will grow the business. Then follow up with written materials later.
It also helps to follow a basic Start-up 101 rule, and tap your own personal finances first before turning to others. Not only do you show that you have a great deal of skin in the game, but you will also have an easier pitch to make because you will have at least a kernel of a business going.
Also, be prepared for some tough love. Especially if it is a friend or relative who knows something about starting or running a business, their point of view many be just what you need.