When a Grubstake Is a Family Affair
"If a deal goes south, it can really screw up Christmas"
When she needed capital three years ago to develop a new specialty computer chip, Weili Dai didn't try to put the touch on one of Silicon Valley's famed ''angels'' right away. Instead, the 36-year-old computer scientist found funding closer to home, getting $200,000 in equity financing from friends and another $150,000 from her parents, Chinese immigrants who run a San Francisco hotel.
Marvell Technology Group Ltd., the company she launched early in 1995 with two fellow Berkeley graduates, has since raised $19 million from investment bankers and venture capitalists. But the initial grubstake, Dai says, was ''critical,'' covering rent and payroll during the start-up's first difficult months. Such intrafamily investments also pay dividends in self-confidence, Dai adds. ''The people who get involved really know you and believe in you.''
Welcome to the world of family financing. It's an approach to raising money as complex, combustible, and rewarding as families themselves. Done right, it can provide patient capital, while building credibility with other lenders and investors. Done wrong, it can break the very bonds of familial affection. No matter what, ''if a deal goes south, it can really screw up Christmas,'' observes Rolf Selvig, director of business development at VentureOne Corp., a San Francisco-based research firm.
PLENTY OF CASH. Long favored by entrepreneurs lacking access to commercial credit, friends-and-family financing appears to be gaining popularity. According to a 1996 survey of 800 male and female entrepreneurs by the National Foundation of Women Business Owners, 43% turned to personal sources for start-up capital. (Twenty-seven percent tapped family members and 7% spouses; 9% were backed by friends.) In the most oft-cited previous study--a 1990 survey of 3,000 businesses by the National Federation of Independent Business--just 30% relied on friends and relatives for at least some start-up cash.
Several converging trends could spur even more family financing. Flush with stock market gains, many families have more money than ever to invest--just when interest in entrepreneurship is booming. Then there's the $13 trillion poised for transfer to the next generation in the coming 20 years. Some older people are choosing to help their children while they're still alive.
But before you decide to borrow or bestow homegrown capital, consider the risks--both financial and emotional. Not every family deal goes as smoothly as Dai's. Patrick Kelly, a Boston-based management consultant, poured his savings, plus a bank loan, into a restaurant partnership with his brother-in-law in 1986. The two never put anything on paper, nor did Kelly check out leases and licenses critical to the deal, he concedes. When the place bellied up after 18 months, Kelly estimates that he lost the equivalent of about $80,000--and something more. It ''certainly divided our family,'' he says. He hasn't spoken to his sister or her spouse in 10 years.
BELOW COST. ''In families, we are accepted unconditionally for who we are,'' says Paul Karofsky, executive director at Northeastern University's Center for Family Business in Needham, Mass. ''In business we are recognized for what we do and how well we do it. Those are two entirely different value systems.'' They are easily confused, though.
''A lot of people don't want to say 'no' to family,'' says Alan L. Carsrud, senior lecturer at University of California-Los Angeles' John E. Anderson Graduate School of Management. He recalls a former student who convinced his new wife's uncle to invest $300,000 in his promising cheesecake business. But the doting investor failed to notice the product was selling at 25 cents per unit under cost. In the end, the young man lost the business, the money--and his marriage.
Even when things go as planned, a family loan can cause tension. Elizabeth Genel and her husband, lawyer Mark Nyman, used $30,000 in loans from their parents as equity to qualify for a $100,000 Small Business Administration loan. Their upscale fragrance and cosmetics store in Westport, Conn., is prospering, and they're living up to loan terms. Yet the couple feels every personal expenditure is subject to family scrutiny. ''When we have gone on vacation, family members have said, 'How did you afford that?''' Nyman says.
To head off such conflicts, Jeffrey Wolfson, a Boston attorney with a family-business practice, often urges clients to approach outside lenders before soliciting family funds. Too much dependency on relatives, he says, ''can create confusion over roles and strain relations.''
Involving an outside lender or investor helps give the family perspective on the proposed business. By the same token, bankers usually regard family contributions as part of the entrepreneur's equity--and evidence that a start-up is more than a hobby. ''You don't want to go back to an aunt or uncle and say, 'I lost the money,''' observes Carl Harris, first vice-president at People's Bank in Bridgeport, Conn. A family commitment can also be leveraged by, for instance, getting a relative to guarantee a bank loan. That worked for Eric Weinstein, owner of Towel Specialties in Baltimore. At 23, Weinstein started his beach-products business with about $7,000 in savings and a $50,000 bank loan co-signed by his father. He later guaranteed another loan for $150,000 so his son could buy a building. Today, 13 years later, it's a $6.5 million business with 45 employees.
So what are the guidelines for making family financing a success for everyone? First, go in with clear and reasonable expectations, stay involved, and get updates, says Deborah Cannon, executive vice-president at NationsBank in Dallas.
Experts suggest family lenders follow many of the procedures of commercial banks. Demand a meaningful business plan that includes well-researched and supported projections. To make clear that the money is a loan, not a gift, draft a promissory note and a written agreement specifying terms. If a business starts to falter, both sides should be willing to renegotiate and perhaps suspend payments for a while.
Proper paperwork and written terms are especially important to avoid expensive gift and estate tax problems. Say you make an interest-free loan to a relative. The IRS treats that as a ''gift'' equal to the amount of interest you should have charged based on IRS-set rates. If the amount of this ''imputed'' interest exceeds the $10,000 tax-free yearly limit, you might be subject to both income and gift taxes. And if the IRS discovers outstanding loans at your death, and there's no formal documentation, the whole loan could be deemed an unreported gift, meaning more penalties and interest, says John Dadakis, an estate tax lawyer at Rogers & Wells in New York.
PATIENCE, PATIENCE. Financial planners increasingly urge affluent elders to invest in their children's present pursuits as part of their overall investment strategy. Donald Ek, 62, has been doing that for several years. ''I'd rather give the money to them with warm hands than with cold hands,'' he jokes. The retired plastics manufacturer, who now lives in Palm Beach Gardens, Fla., has disbursed some $2 million in loans or gifts and co-signed bank loans to help finance businesses of his four grown children and their spouses. Without Ek's $400,000 loan for expanding his showroom and inventory, son-in-law Rick Erickson says he'd have a $1 million business repairing motorcycles, snowmobiles, and jet skis, not a $7.2 million dealership. Although not every one of Ek's children has fastidiously repaid the loans, Ek says it's because of ''usual'' business problems. ''We talk things over. What I won't accept is if they're not doing something to deal with the problem,'' he says.
Beyond all else, the patience of well-conceived family financing can be its greatest virtue. Consider the history of Santa Clara (Calif.)-based Aveo Inc. In 1987, Paul Hurley, the chairman and chief executive of the company, and his brother got $300,000 from family in both debt and equity to launch Cypress Research Corp., a company that developed a fax-server telephony product to operate with Apple Computer Inc. computers. In part because of Apple's flagging sales, the market never materialized. But because the family stayed behind them, the Hurleys were able to regroup in 1991 as Aveo and create MegaPhone, a desktop-communications product that now commands $4 million in sales. The company has raised $6 million from venture capitalists and private investors and hopes to go public soon, Hurley says. He admits he felt guilty at times when he fell behind on loan payments, but says the guilt also prodded him to succeed. ''Starting with family money is a great mechanism to teach you the value of protecting your investor's money and acting in his best interest,'' he declares.
If the venture capitalists made a good bet on Aveo, his family will not only be proud of him if the company goes public--their stock could be worth millions. That outcome, for any investor, is really something to write home about.
By Paul Sweeney in New York
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