Small Business

Friends and Family Funding Your Startup?


I have started a new business and will be asking friends and family to invest. I plan to ask for at least $10,000 from each investor for a total of $100,000 in seed money. I will pay 6% interest over a five-year investment. Is this fair? Should I have a lawyer draw up a financial agreement for my investors?—A.L.

"With friends like you, who needs enemies!?" asks Peter Cowen, an investment banker with Peter Cowen & Associates, based in Westwood, Calif. What you may not appreciate is that new businesses are illiquid and risky investments, with statistically high failure rates. Looking at it from that perspective, your proposed rate of return is far too low, Cowen says.

"Perhaps if you personally guaranteed this investment and had substantial other collateral outside of this new venture, you might reduce your investors' risk somewhat, but even then the rate of return is extremely low." In high-risk startup situations, investors typically expect annualized returns of 25% to 35% or more, he says.

Let's put your proposal into perspective: Your friends and family members could purchase bonds from blue chip companies like IBM (IBM) or Hewlett Packard (HPQ) that carry very low risks and yet still offer higher returns than what you're proposing. Plus, those bonds can be cashed in at any time, so they offer true liquidity. Unless you can offer more to your friends and family, they will have little incentive—beyond blind loyalty—to invest in your precarious new venture.

ESTIMATED VALUE." Typically, the less established the venture, the higher the risk and therefore the higher the return someone needs to receive. In addition, if the investment is illiquid—meaning the investor must wait a long time to have the opportunity to collect—then the investor is entitled to an additional premium for this wait," Cowen explains.

Investment deals are generally structured by starting with an estimated valuation of your new venture. For example, if you determined your business was worth $300,000 and you received $100,000 from your investors, they would own one-third of the company or 33.3%. "On a deal I recently invested in where there was already millions in value, for $100,000 I will receive 15% interest per year, accruing for two to three years, plus about 1% ownership," Cowen says.

"In another deal, I and a group of investors put about $500,000 into a company with exciting technology and some initial customers. We received about 20% ownership, plus warrants (a chance to buy additional shares at a low predetermined price) for another 5% ownership. In addition, we structured the deal so that we are repaid all of our investment first, plus 10% annual interest, before the investor receives anything in the case of a sale."

SIGNED AND SEALED. In answer to your second question, you absolutely should have a lawyer draw up the proper financial documents. By law, people who go into risky ventures like business startups must be "accredited" investors. "By definition these are people who have a net worth of at least $1 million or have generated net income of $250,000 or more in the last two years," Cowen says.

"These investors must sign documents attesting to being accredited investors, or you could be opening yourself up to potential lawsuits." Although startup entrepreneurs often are not familiar with the rules about investors, that doesn't exempt them from liability if a deal goes sour and investors seek legal recourse, Cowen says.

Before you approach anyone about investing, talk to an attorney, business consultant, or investment banker and come up with some more realistic assumptions. At the same time, make sure that you have calculated your startup capital needs accurately. "Your startup capital should last at least one year—ideally two years. Needing more capital after a few months is usually a prescription for disaster," Cowen notes.

You should have detailed cash flow projections and a built-in margin of error to cover the inevitable delays that occur. Also make sure that one or two people with business experience, whom you trust and respect, have looked over your projections and assumptions. Startup companies have enough risks—don't saddle yourself with the problem of poor planning before you even open for business.

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