Join Rudolph Rosenberg for an in-depth discussion in this video Borrowing money from friends and family, part of Entrepreneurship: Raising Startup Capital.
- One of the first ways people usually consider to raise money is to turn to their friends and family to lend them the capital they need to start their company. It often sounds like a great idea, because those people are easily accessible and want to see you happy and successful. But the nature of the relationship itself, and the fact that those people are so close to you, is actually what makes it the most dangerous ways to raise money. When you raise funds through professional investors, everyone knows what the stakes are, what the potential upside is and, of course, the hard reality that 80 percent of all startups fail eventually, and that there is a very real risk of losing your entire capital.
With friends and family, it is actually quite different. Their motivation to invest in your business is actually related to the fact that they want you to succeed or to send you the message that they believe in you and want to support you in your entrepreneurial efforts. They might even be reluctant to give you their opinion, if it's negative, so as not to demotivate you or have you thinking that they're not supporting you. Usually, it even goes one step further, which is that friends and family can be reluctant to do any paperwork to formalize your agreement.
When you're in that first phase, where everything is still possible, everyone is very happy. You're getting the money, and your friends and family are happy to help you, but usually things get complicated further down the road. The question is, what happens if your company meets difficulties, and you're not able to repay the loan? Is that going to be an issue? If your company files for bankruptcy, do you expect to repay the loan anyway? Those are all questions that need to be answered upfront.
When you're dealing with an institution, all of those things are set in stone as soon as you sign the contract. You know who is responsible for the loan, what will happen if you miss a payment, and the full consequences of not being able to repay the loan. With friends and family, you need to have the same level of rigor in the borrowing process and define all those things. The benefit of doing so is that if things do turn sour, then there is no relationship or family issues added on top, since it will all have been defined in advance.
For example, if you're having temporary difficulties, you need to define how you will handle it. Will you stop the monthly payment for a time, until your finances are better? Is your lender okay with that, and does he have the financial stability required to live without that money? If your company files for bankruptcy, will you be repaying the loan or not, and if so, will it be okay for your lender to wait until you have a new source of income to repay the loan? Will they accept a smaller monthly payment over a longer period of time? And even if you do, remember that those people are your friends and family, and they might, therefore, have an opinion on how you use your money.
For example, they could be okay to reduce your monthly burden and take it on themselves to let you repay the loan over a longer period of time, but they might also feel bad if they see you going out or on vacation, instead of paying them in an accelerated way. You, of course, might feel like this is a well-deserved night out or vacation, but chances are they will see it in a very different light. They might feel like they are financing your vacation. Those are things you need to take into consideration when borrowing money from friends and family.
Getting the money is usually the easy part, but the consequences down the road can be terrible. So, what's the best way to borrow money from friends and family? First, you need to treat them like strangers, as far as paperwork is concerned. Don't fall into the trap of believing that oral agreements are sufficient, just because you know each other. Then, protect their interests better than they will. As I said earlier, they will not want to protect their own interests, so as not to lead you to believe they mistrust you.
So, you have to do the job and insist on putting everything on paper. Go over every possible outcome, and then put in writing the way you will manage it. It is so important that I will say it again. Put everything in writing. Don't rely on your memory or theirs to know what was originally said. And by the way, even if we all had good memories, we also all have different interpretations of what we say. Putting things in writing helps a lot in clarifying the agreement.
Even if that document might not have a legal value, it will be a great way to preserve your relationships. Borrowing money from friends and family is a dangerous game. If you must do it to get started, or if there's no other way to get your company on its way, then do it, but put it all in writing and defend the interests of your friends and family as your own.
- Estimating the capital you need
- Understanding the four big sources of capital
- Valuing your business
- Making a business plan
- Using your own funds
- Limiting your personal liability
- Making crowdfunding a part of your strategy
- Borrowing from friends and family
- Working with angel investors and VC firms