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Friends, Family and Fools
Friends and family members may want to support your business venture by lending or gifting funds to you. In some cases friends or family may want to invest or purchase an ownership interest in the business venture. This is the most basic form of crowdsourcing the business venture. You collect funds from a larger group of people who have a vested interest in your success. Each year between 35-40% of startup ventures receive capital from friends and family.
This group is commonly called “friends, family, and fools.” The reason fools are grouped into this category relates to the risk associated with lending or investing in a seed venture. Generally, these individuals are not sophisticated investors; rather, they invest in a foolish or whimsical manner. As such, it is strongly advisable that any business loan or investment follow all formalities for a typical lender or investment relationship. Loans should be made with a well-drafted promissory note, and equity investment should be pursuant to a negotiated term sheet (with all relevant provisions).
Benefits of Friends and Family Financing
Generally, friends and family financing does not involve the formal review process or due diligence involved in commercial loan or angel investment situations. That is, friend and family are not going to conduct a thorough review of your credit history or require extensive collateral to secure the loan. The friends and family relationship is also generally flexible with regard to repayment options and applicable interest rates.
Process for Approaching Friends and Family for Financing
Obtaining money from friends and family can be a risky proposition for the relationship. Money is a touchy subject. The awkwardness in the relationship is magnified by any uncertainty in the relationship. With that understanding, it is advisable to apply a formal approach when asking or seeking funds from friends and family. The following is a proposed process for seeking funds:
- Have an understanding of what type of deal you seek.
- Note: You need to determine whether you want a debt or equity relationship. What should be the terms of each (company valuation, interest rate, how much are you seeking, etc.). Much of this information will be included in the business plan.
- Hold a formal meeting to pitch (explain) the business.
- Note: Do not try to negotiate this during a single meeting. Give the friend or family member time to think over the situation.
- Provides a professional business plan.
- Note: The business plan should have a detailed SWOT analysis. Further, the investor should provide a detailed explanation of the potential risks associated with the business.
- Provide any product or service information, supporting information, or due diligence relevant to the business.
- Use formal documents to memorialize the relationship
- Note: Use a well-drafted promissory note for a debt arrangement. Use a subscription (purchase) agreement and Buy-Sell Agreement for equity investments.