Get the working capital your business needs–learn more about Entrepreneur Lending, powered by CAN Capital »
The following excerpt is from the staff of Entrepreneur Media's book Finance Your Business. Buy it now from Amazon | Barnes & Noble | iTunes
Have you heard of “FFF” money? FFF stands for family, friends and fools. Many new entrepreneurs receive the initial funding for their businesses from people close to them, causing these relationships to start sliding toward disaster. Over his 15-year career as an entrepreneur, Josh Steimle borrowed from all three groups, making him an excellent source for what to watch out for when borrowing FFF money.
Related: The Basics of Borrowing From Friends and Family
Although some of these funding arrangements have happy endings, all too many end painfully, with consequences ranging from unfortunate to disastrous. Before considering FFF money as an easy way to start your business, consider the following.
Money changes people
Nobody starts out in a marriage saying, “How can I use money to ruin this relationship?” But many couples seemingly do. Financial disagreements are the number one predictor of divorce in the United States, according to one study. The person you dated and were madly in love with before you married can become another person entirely when finances enter the picture.
Money changes people in business relationships as well. Finances will cause contention when there isn’t enough when there’s too much, and at every point in between, no matter how great a person you are or the lender is.
The borrower is a slave to the lender
Many have said that the day you take a loan from someone, you become that person’s slave until you pay off the last cent. The lender may claim that they don’t mind and just want to help you succeed.
But wait until you take a vacation in Hawaii, buy a new house or car or even choose a more expensive dish at a restaurant than they do. Then the lender might start thinking, “Wait a second. I gave this guy a loan, and he’s spending money on this instead of paying me back?”
Your business may fail
Most small businesses do. Think yours will be the exception? So do the roughly half of U.S. business owners who shut down their companies within the first five years of doing business.
What’s your plan if your great idea doesn’t work out? Will you feel OK telling investors you’re sorry you lost their money or will you feel obligated to turn investments into loans and pay them back? In the latter case, what will be your plan for paying the loans off?
Given the risks, what can an entrepreneur do to reduce the chances of a family loan harming a personal relationship?
Much of Steimle’s initial exposure to entrepreneurship came from his father’s granting him a $1,000 loan when he was in high school so he could launch a retail skateboard business. That experience and others left him with mixed feelings.
Related: The Ins and Outs of Microfinancing Your Small Business
Tips on avoiding trouble
Here’s some advice Steimle gave his dad that he feels can be broadly applied to anyone considering borrowing from a family member or friend:
1. The dynamic should resemble that at a bank, not one between relatives. Repayment should be required. Payment terms can be flexible, but the borrower shouldn’t be let out of the loan. This is for the borrower’s sake, not the lender’s because the lesson learned otherwise is that it’s OK to borrow money from people and not pay it back. That’s not a good lesson for anyone of any age to learn.
2. Set up a payment schedule. If the new business isn’t generating enough income to repay the loan, the borrower should earn the money some other way and send the payment every month, no matter what. A penalty should be charged for late payment any month a payment is missed and every month thereafter until the borrower catches up.
3. Pay interest. The way the real world works is by charging interest on loans. If the borrower wants to pay less interest, repayment should take place faster.
Going into debt to start a business is less than ideal in almost all circumstances. Borrowing from family and friends risks incurring personal fallout. But when this is the only way to start or fund a business, following these steps can greatly reduce that risk.
The right way to ask your parents to finance your business
Alex Genadinik borrowed $20,000 from his mom to launch Problemio, a startup that makes mobile apps for small businesses. Since 2012, Carlo Cisco has taken $150,000 in convertible note investments from his relatives to expand Select, his New York City dining, travel and entertainment discount club. And Andrew Angus has borrowed $500,000 from his mom (half her net worth) to keep up with the exponential growth of Switch Video, his animated video production company, which was acquired by Vidyard in 2015.
None of these transactions came without consequence or regret. “It might be the easiest money to get,” Cisco says, “but it’s probably going to be the most important money you ever have because you’re not going to want to let them down.”
If you plan to spend Thanksgiving dinner hitting up Mom and Dad for startup cash, first listen carefully to what these entrepreneurs recommend:
1. Invest your own money first. Cisco, a former Groupon staffer, burned through $40,000 of his savings to launch FoodFan, a restaurant-review website that was the precursor to Select. A $100,000 convertible note from investors helped him forge relationships with restaurants and create an early version of his platform. By the time he asked his family for cash, FoodFan listed 850,000 restaurants and 50,000 menus. “We had an incredible brand name and a massive amount of data,” Cisco says.
2. Hit up strangers. Third-party validation from outside financiers can strengthen your pitch to the parents. Angus, who launched his business in 2006 in Collingwood, Ontario, says a $250,000 loan from Canada’s Centre for Business and Economic Development helped him sell his mother on his plans. Angus’ mom opened a home-equity line of credit to pay off his loan at a lower rate and now has a convertible note investment in the company, to be paid back in five years with a 6 percent annual interest rate.
Cisco seconds the suggestion to tap outside investors. He turned to relatives only after several angel investors offered him amounts ranging from $25,000 to $100,000 each in exchange for 6 to 10 percent equity — slices of the pie he felt were too big to give away. Through convertible-note loans from his family, Cisco held off on negotiating a price for his company too early. When he finally did raise an additional $150,000 from outside investors, his family’s stake in the company converted to straight equity.
3. Get it in writing. Genadinik admits he regrets the “very, very informal” loan agreement he made with his mother. There was no timetable, no interest rate, no contract, nothing. Roughly six months later, his mom wanted her $20,000 back. Although Problemio had revenue by then, Genadinik didn’t have the cash lying around. Rather than ruffle Mom’s feathers, he took out a short-term microloan and sold $15,000 in stock to pay her back, incurring unwanted interest and costs in the process. Lesson learned: Sign a contract with family financiers so that expectations are crystal clear.
Related: Buying a Business Through Seller Financing
4. Don’t ask for too much. If Switch Video had failed, Angus’ mom would have lost her home. Fortunately, business took off, with more than $2 million in annual revenue and customers such as Facebook, IBM, HP, Microsoft and American Express, culminating in a move to the Bay Area and later, the acquisition by Vidyard.
As with everything, it seems, there are advantages and disadvantages to using family money.
- Highly likely to say yes
- Better financing and equity terms
- Faster access to cash
- Relatives meddling in the business
- Smirks from industry insiders
- Lifetime of guilt if startup tanks
Select founder Cisco cautions against borrowing more than your parents can afford to lose. “You do want the amount to be enough that you have a shot,” he says. “But you don’t want it to be so much that someone has a problem if it doesn’t work out.” Remember, you will have to face these people for many Thanksgivings to come.