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Friends and Family Funding for Startup Companies

By Beacon Staff

Capital is a vital resource for launching new companies and the largest source of capital for startup entrepreneurs in the U.S. is “Friends and Family” (F&F). The popular press would have you believe that venture capital is critical to an entrepreneur-friendly economy. But, as we have discussed previously in the Entrepreneurs’ Corner, the availability of venture capital varies widely across the nation, with about 65% of the $20 billion invested annually flowing into companies located in California and Massachusetts. Companies in over half of US states rarely receive venture capital. Montana has, on average, had only one company per year financed by VCs in the past decade.

While angel investors have been funding US companies since the founding of our country, the availability of angel capital has only become common knowledge in entrepreneurial communities in the past 20 years, and is still a rather unknown quantity. Yet, angels invest the same amount annually in the US as do VCs ($20 billion per year), and in every state in the union.

The good news for entrepreneurs, according to the Global Entrepreneurship Monitor (Babson College & London School of Business), friends and family members of entrepreneurs invest $50 to $75 billion annually in US startup companies – wow, about three times more annually than angels or venture capitalists! The largest source of capital to entrepreneurs is right next door and well known to entrepreneurs far in advance of need!

And, not only is F&F funding readily available, it is the only source of capital obtainable by entrepreneurs at the earliest stage of development – at or immediately after founding the company. Angel investors generally won’t provide capital to startup entrepreneurs until customers have validated the product (or a prototype). And, venture capital is not usually available until after new companies have substantial revenues. Only friends and family will fund entrepreneurs as they develop products and business models; set up offices and factories; and write business plans. This development or pre-seed capital is vital to new companies yet not available from angels or VCs.

(For the sake of completeness, about $3 billion annually in government funding is available to developmental and pre-seed stage companies, mostly from federal agencies as Small Business Innovation Research contracts or grants. While important, especially for high technology startups, the annual budget for such funding pales in comparison to the capital available from entrepreneurs’ friends and families.)

Just who are these friends and family investors? Entrepreneurs commonly pursue investment from anyone they know personally who can afford to make the investment, such as parents and grandparents; aunts and uncles; neighbors; and even their minister and high school principal. If you are an entrepreneur raising capital for your startup venture, it is important to understand that friends and family members invest in your business because they believe in YOU, that is, the entrepreneur’s demonstrated work ethic, integrity, curiosity and passion to succeed. These F&F investors usually lack adequate business savvy to either evaluate the investment opportunity presented or advise entrepreneurs on growing their business. In fact, they are not investing in your company…they are investing in YOU. Sit down with candidate friends and family investors, explain your business plan to them and ask for the money. You will be surprised with your success.

BUT…don’t just accept their checks with a grateful thank you. Discuss the nature of their investment…and then document each investment in writing. Is this cash a gift? Is this a loan? If a loan, what are the terms and conditions of the debt? Is this an equity investment, for which the investor expects shares in the company? If equity, for what number of shares in the company? While these questions seem trivial at the outset, they may become critical in the future. If you and your friends and family investors do not decide in advance, you may be allowing these investors to decide later. If dear old Aunt Emma has provided $10,000 to help you start your company and the company fails, she may decide the investment was debt and want her money back from you personally! On the other hand, if she later decides the investment was equity and the company is successful, then just how much of your new company does Aunt Emma own? The author is not advocating a position (gift versus debt versus equity); instead I am urging entrepreneurs who accept friends and family investment to clarify the expectations of the investor.

One of the biggest mistakes entrepreneurs can make is neglecting to clarify the relationship with friends and family investors. Whether this business succeeds or fails, relationships with friends and family are important to maintain. Entrepreneurs routinely successfully pursue funding from friends and family. Friendly advice: Clarify the nature of the investment at the outset!

Capital from friends and family is the largest source of funding available to U.S. entrepreneurs and it is rather easy to raise. Friends and family are readily known to entrepreneurs and F&F don’t necessarily require a complete business plan prior to investing. Don’t overlook this huge source of capital available to entrepreneurs in America!