Friends and family can be excellent sources of startup capital for your business. In fact, a Kauffman Foundation survey discovered that 28.4 percent of the fastest-growing companies in America borrowed from family and friends. Add in business acquaintances, and that figure jumps to over 40 percent.

There’s no doubt friends and relatives can help fund your startup: They’re easy to approach, offer favorable terms and are likely to believe in you. Here’s how to ask family and friends for startup cash the right way, so you can avoid the pitfalls that can destroy your business and relationships.

Create the right structure

Structure your arrangement as a business loan, equity investment or a gift so it works for your business and your family and friends.

  • Business loans. The friends or relatives who loan you money typically do not have an ownership stake in the business, but you should set an interest rate (if applicable) and repayment schedule.
  • Equity investments. Friends and family purchase shares in your business. This can be tricky because it’s difficult to accurately valuate a startup; if you give your business the wrong valuation, it can complicate later funding rounds and prove unfair to friends and family members who overpaid for their initial shares. Shareholders own a stake in the business, and if you go this route, you need to define whether they play a role in decision-making.
  • Gifts. Gifts are simple in that they do not involve repayments or shares. They might have tax benefits for friends and family (speak to an accountant or other financial professional to find out). If you’re gifted money for your startup, be sure to make it clear that the funds are indeed a gift and no repayment is expected — an agreement that may need to be in writing.

Business loans are often the preferred funding method for small businesses. They’re much simpler than equity investments, and they offer a path to repayment (sometimes with interest), which can avoid hard feelings later. You can set up a business loan with a promissory note or pay a peer-to-peer lending service to manage the loan, though it’s often best to hire an attorney for assistance.

Hire an attorney

No matter which structure you choose, it’s a good idea to hire an attorney to draft a legally binding document that clearly details the terms of your arrangement. Doing so can avoid problems later, hold you accountable and ensure that your friends and family members completely understand how their money is being used.

Legal documentation should include:

  • Funding amount
  • Loan terms, including repayment schedule and interest
  • Ownership shares
  • Decision-making roles
  • Gifts with no expected repayment
  • Rights of your lenders or shareholders
  • Your responsibilities as the borrower or share seller

As you draft legal documentation, try to think through potential complications. For example, what happens if you miss a loan payment? What if your friends or family members want to have a say in the business? Do they have voting rights? Can you appease them with a seat on an advisory board that has no legal decision-making power? Are you expected to report to shareholders?

In most cases, friends and family members won’t want to be involved in your business — they’re giving or loaning money because they believe in you —but it’s best to spell these things out in advance to avoid problems if your business struggles. Keep in mind that issues could arise if you’re wildly successful, especially if you’re selling shares and those shares rapidly increase in value (another reason to opt for a business loan structure).

Ask for enough money

It’s tempting to only ask for enough money to scrape by. But that thinking can be shortsighted; being undercapitalized can often contribute to the failure of your business. And if your friends and family members can’t afford to invest or loan the money, you’re better off seeking funds elsewhere.

Put yourself in their shoes: Would you rather give less and see a loved one fail, or give a little more and contribute to their success of the business?

You can pool funds from different friends and relatives, too — you don’t need an equal buy-in across the board. Create a solid business plan that includes costs, market research and revenue projections to determine how much you need after your personal investment. Then, ask for the full amount. Account for inaccuracies and unexpected outcomes, and ask for enough money to cover expenses until your business can reliably turn a profit.

Make your pitch

Start by telling your story. Friends and family members want to feel your passion and get excited about your startup, so explain your business, your potential customers and how this endeavor will help fulfill your dreams.

Then, treat friends and family members like you would any other investor: Be prepared with a business plan, market research and pitch deck that spells out your vision, why you need funding, what the money will be used for and how it benefits your lenders, investors or benefactors.

You probably don’t need to create a complicated slide deck that goes into extreme details about your business — after all, you’ll likely be making your pitch at a kitchen table — but it’s a good idea to demonstrate you’ve done your due diligence and can confidently explain why you will be successful.

The more seriously you take your business, the more likely your friends and family members will be to believe you can executive your strategy. Plus, it’s great practice for pitching to traditional lenders and investors.

Fully explain the risks

It’s easy to get caught up in your own hype, but you need to protect your relationships. Plan on clearly explaining the risks to friends and family members.

Answer this question: What’s the worst-case scenario? If friends are loaning you money, you could go bankrupt, leaving you with no ability to pay them back. If family members are buying shares, your company could go under, and they’ll lose their entire investment. If your parents are giving you a gift, bad business decisions could put you back at square one, albeit without the money they gave you.

Keep in mind money isn’t the only factor; a poor experience can lead to bad feelings and soured relationships. Worst-case scenarios do happen and if this is overwhelming to you, you should consider seeking funding sources elsewhere.

Remember that your friends and family members might not be seasoned entrepreneurs, lenders or investors. They want to believe in you — and they should — but you need to protect their money and your relationships by being upfront about the risks.

Friends and family are some of the best startup funding sources for small businesses. Use these tips to make sure expectations and risks are clear, arrangements are structured properly, and your pitch is convincing, so you can confidently ask friends and relatives for startup cash now and avoid potential pitfalls later.

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