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When Michael Caron founded a window-cleaning service in 1985, the recent university grad needed cash to get the business off the ground. So, he borrowed almost $30,000 from each of his mother, grandfather and best friend. He rented 14 cars, hired workers and waited for the window-washing cheques to pour in.
Trouble was, they didn’t. His business model was unproven, his cash flow was decidedly negative and his overhead was overwhelming. The business soon failed; Caron lost all the seed capital. His investors were left with nothing. “We had no paperwork whatsoever,” he recalls. “I was overwhelmed with guilt for losing their money, and I promised I would pay them back.”
Caron got a new job and, six years later, fulfilled his promise. But the experience taught him a painful lesson shared by so many entrepreneurs. As Stewart Thornhill, associate professor of entrepreneurship at London, Ont.-based Richard Ivey School of Business, explains, the vast majority of startups—and many older businesses with expansion plans or a cash-flow crunch—turn to friends and family for financial support at some point. The generosity of these financiers, he says, always comes with risks. “The businesses that are going to go under will often do so fairly early in their life,” Thornhill points out. “So, friends and family who are the first in will likely bear the brunt of those early failures.” The Catch-22 for entrepreneurs, he adds, is that in many cases, formal lenders and investors will often look for friend-and-family money in a business before committing their own funds.
The need to ask friends and family for cash has only grown since seed funding dried up during the recent recession. Banks are as risk-averse as ever when it comes to supporting new, unproven businesses or fast-growth firms. And there remains a relative dearth of angel and venture capital. Seeking a loan or investment from those in your personal life is a far easier sell; after all, Mom is unlikely to foreclose if the business goes bust. Yet, the process can be fraught with peril, and the stakes are high. Family barbecues can become exceedingly uncomfortable if loan payments or dividends aren’t issued on time—or at all—while failure can result in the loss of a family member’s personal fortune.
For those who approach friends and family for funding (by choice or necessity) there are several tried-and-true tactics that can boost the prospects of an investment or loan arrangement being successful. From drawing up shareholder and loan agreements to communicating progress in the roller-coaster ride that building a business can be, entrepreneurs need to plan wisely and tread carefully to make sure their personal relationships don’t implode. Here’s how you can do it:
Ensure your pitch is crystal clear
Although serial entrepreneur Caron, now 48 and the founder of Edmonton-based sales-training consultancy Northbound Learning Inc., was bitten by his early experiences, he wasn’t deterred from approaching friends and family for investments in subsequent ventures. For one new startup, Berkeley Medical—a health-care data-management software firm he founded in 2004—Caron needed to drum up about $1 million. He raised the necessary funds in the form of equity investments from 17 shareholders, all friends and family. But this time, his approach was very different.
Caron approached potential investors at social events or during visits to their homes early on in the startup process to discuss his idea. If they were interested, he would invite them to learn more about the company. Caron tailored his language carefully, explaining possible benefits conservatively but enthusiastically: “I did a formal presentation and treated them as if they were arm’s-length investors. I emphasized that it was high-risk because if it didn’t pan out, I wanted to be sure that I hadn’t oversold it.”
Thornhill says that entrepreneurs have an obligation to understand the risk profile of their friends and family—and to turn down any money the potential stakeholder can’t afford to lose. “You have to think through what that Thanksgiving dinner is going to be like if you lose your father-in-law’s retirement nest egg,” he says. “If you’re not willing to put yourself in that place, you have to figure out another option.”
To that end, Caron and his partners refused funds from a friend’s mother living on a fixed income, since they felt that losing the money would adversely affect her life.
Get your deals in writing
Ted Bradshaw found himself in the midst of the bursting dot-com bubble in 2000, leaving him unable to attract venture capital or angel financing when starting his second company, education software maker Students Achieve. So, he also went to friends and family, raising $800,000 from 14 investors.
Bradshaw, now CEO of Edmonton-based online gaming firm Visimonde, Inc., insisted on carefully structuring his agreements with shareholders. He hired legal counsel to organize the terms—a wise move, according to Jeffrey Kahane, principal at Calgary-based Kahane Law Office: “Don’t let emotion get into it. That way if anything goes sour, there aren’t any bad feelings.” For loans, Kahane recommends setting terms for repayment, including interest rates or rates of return, a date for repayment and what will happen if the loan can’t be repaid. The same principles apply to equity investments, although key clauses, such as one governing the process by which shareholders can exit the company, need to be included. Kahane says that legal costs can run between about $300 for a promissory note and $3,000 for a detailed shareholder agreement.
In Bradshaw’s case, he and his partners offered Students Achieve investors equity in the company with no timelines or direct promises on returns, merely defining ownership stakes in the agreement. Bradshaw also laid out conservative earnings scenarios. He sold the firm in 2007, doubling the investment of his early investors. Prior to selling, he had advised the investors that growth and returns would stagnate without extra capital, and made the case for an exit. They agreed. “I felt good about it, because I thought it was the best deal we would do,” Bradshaw recalls.
Create open lines of communication
When it comes to communicating news to your investors, Andrew Patricio, co-founder of Toronto-based startup consultancy BizLaunch Media Inc., recommends meeting in a formal setting—such as your office—at least every 90 days to discuss progress. And if things aren’t going well, he says, investors need to be told well in advance.
With Berkeley Medical, Caron held quarterly progress meetings with his shareholders and sent detailed email updates every month on the company’s financials. “One of our investors told me, ‘You overinform us,’” Caron recalls. “It was worth it, because no one ever said, ‘You kept us in the dark.’”
For his part, Bradshaw found it helpful to acknowledge his friend-and-family investors’ potential lack of business acumen and prepare his communications in vernacular they could easily understand.
Overall, Bradshaw has no regrets, noting that his steadfast approach not only provided significant returns for his investors but also managed to preserve harmony with his friends and family. While there is no guarantee things would have ended so happily if he’d lost their money, Bradshaw feels that a proactive and well-documented approach like his will increase the likelihood of personal relationships surviving any business outcome. “I think if you lay it all out with a good plan, passion and the caveat that, ‘This is risky, but if you lose, I’m going to lose with you,’ it saves a lot of issues down the road,” he says.
Originally appeared on PROFITguide.com