Recent Articles

Jul 31Doug Smith

The Dilemmas of “Friends and Family” Funding for Start-up Businesses

Jul 31Doug Smith

Since the 2008 financial meltdown, it has been difficult for small business startups to get bank loans. More businesses have turned to “friends and family” investment for funding to cover early expenses and kickstart growth. However, according to a recent article in the HBS Working Knowledge blog, such funding can either be a blessing or a curse.

In his new book, The Founder’s Dilemmas: Anticipating and Avoiding the Pitfalls That Can Sink a Startup, Harvard Business School Associate Professor Noam Wasserman tells readers how to anticipate, avoid, and, if necessary, recover from the landmines that can destroy a nascent company before it has the chance to thrive.

Drawing on more than a decade of researching smashing successes and painful failures alike, Wasserman walks readers through the dilemmas that plague and challenge most new entrepreneurs, starting with pre-founding career dilemmas: Is this the right time to start my company? Do I have enough career experience? (About 5 percent of students at HBS decide to leap into entrepreneurship immediately upon completing the MBA program, but up to 50 percent will have founded a company within a decade of graduation, according to Wasserman, who teaches in the school’s Entrepreneurial Management division. His second-year elective course, Founder’s Dilemmas, was a building block for the book. Last spring, HBS offered four sections of the course to 272 students; it was so popular that another 170 students were wait-listed.)

Wasserman also discusses founding team dilemmas in the book: Should I launch the company solo or with cofounders? Who should my cofounders be—friends, relatives, prior coworkers, strangers? Which role should each of us take? How should we divide equity? He goes on to delve into the myriad issues that extend beyond the founding team as the company starts to grow: What types of hiring challenges will I face? Which investors should I try to target at my company’s various stages of growth—and what challenges will they introduce? Will I be replaced as CEO at some point, and, if so, will I maintain a role at the company or exit gracefully?

Released in March 2012, the book has received rave reviews. Publisher’s Weekly called it a “seminal work on the startup phase of the entrepreneurial venture … captivating,” and Dharmesh Shah at OnStartups.com called it “the definitive book on the topic.” (“If you are a founder or thinking about becoming one, you should read this book,” Shah wrote.) Jeff Bussgang, a general partner at the early-stage venture capital firm Flybridge Capital Partners, blogged, “Rather than having [founding] decisions happen by chance, Wasserman’s book is a towering guide to making these decisions thoughtfully and purposefully. Every founder should read it—and take the time to digest its rich data and lessons.”

In this excerpt from Chapter 9, Wasserman discusses the advantages and disadvantages of a common but risky practice among company founders: recruiting friends and family members as potential investors.

To the extent that founders tend to be very confident in their startup’s prospects, they may even be more inclined to take money from friends and family, happily imagining those close to them sharing in the startup’s future success. One founder-CEO, acknowledging that complete certainty is almost never attained, said, “If you know that you won’t lose their money, you should take it.” In fact, whether a founder is willing to risk taking money from friends or family may be a good indicator of whether or not that founder has laid a solid groundwork for success. One founder-CEO said that “if you think there is a real possibility that you might lose their investment, maybe you haven’t addressed all the risks” and should take the hint to think again and try harder to reduce them.

However, many other founders see friends and family as, at best, a last resort. Brian Scudamore was uncomfortable with the idea of taking money from relatives, even though at one point his startup was about to fold for lack of cash. He explained, “My dad could have given me the money. However, I didn’t want him to worry that things weren’t going well … I wanted to show dad that I could do it myself, even if that meant stretching things a bit too far. Also, taking money from him would cause problems if things went sour.”

Brian’s last point worries many other founders and investors. Just as cofounding with friends and family creates the Playing-with- Fire Gap discussed in Chapter 4, taking money from friends and family can put important—even crucial—relationships at risk and, if things go badly, leave them in ruins. Founders who are confident in their startups’ prospects and who are passionate about their ideas often discount the possibility that the startup could fail, but founders and investors who have already been burned by playing with fire take a very different view. One experienced advisor of startups observed, “If you go into business with money from friends and family, then you will either lose the business or lose your family, and have a very good chance of losing both.”

A serial entrepreneur explained, “Out of principle, I do not include family in business/financial transactions or pursuits. The fact is, money stands to be the very thing that can dissolve the strongest of relationships. Added to the prospect of ‘family drama’ (of which everyone seems to have plenty), it’s not worth it.”

One way around this can be to treat an investment from a friend or relative as a gift rather than an investment; that is, with no particular expectation of being paid back. As one founder put it, “To avoid any problems, just ask them to close their eyes and donate money to you.” Speaking from the other side, one investor said about investing in a startup founded by a friend or relative, “I sometimes do it, but I regard it as a gift, not an investment.”

In addition to introducing playing-with-fire problems, taking money from friends and family may send a negative signal about the startup’s prospects, especially if the startup is beyond the early launching stage. One serial entrepreneur observed that founders who fail to raise capital from professional investors and then have to raise from friends and family should think twice about the startup: “If you can’t convince someone more objective than your friends and family to invest in you, there’s probably a flaw with your business, which will result in them losing their money and you feeling terrible. Even if you have a dozen rich uncles, I would suggest you find someone outside that circle who believes in you and your idea.”

An experienced investor said, “It’s a shame to lose friends or family because they invested their savings in the business and lost it all. It becomes a tragedy when the business concept was flawed from the beginning … Why do people take such a risk when there’s plenty of other money out there? Because [friends-and-family] money is too easy to obtain, which encourages people to start marginal businesses. Beyond that, friends and family do little diligence, have no real objective judgment, and can’t advise/prevent you against doing something completely stupid.”

Another experienced VC suggests that some founders may simply not know what their funding options really are: “The reason people usually go to [family and friends] is that they don’t have other choices—or more likely, they don’t know they have other choices.”

Pulling together these considerations, one serial entrepreneur offered this rule of thumb: “If your family comes from a business background and are well-informed about finances and they know to keep business and friendship strictly apart, you should utilize them. However, there are clearly too many ifs, ands, or buts in this scenario, so founders would be well advised to search for financing in other places.”

Just as cofounding with friends and family should be accompanied by carefully constructed firewalls and explicit discussions about worst-case scenarios, so too should any financing from friends and family, or else founders should resist the temptation to take such money.

“Burning the Boats”: Productive Motivation or “Entrepreneurial Suicide”?

Taking money from friends and family may not only make a startup possible, but also profoundly affect how—and even why—the founders try to grow or exit their businesses. For instance, taking such money may enable founders to persist through the scary drops of the entrepreneurial roller coaster, not simply because they have money with which to do so but because they don’t dare give up.

Scott Cook, the founder-CEO of personal-finance software company Intuit, tried to avoid raising capital from friends and family. But 25 failed pitches to professional investors later, he gave in and borrowed from his parents’ retirement savings and from his cofounder’s friends. Altogether, he “spent about $350,000 on Intuit, a sum pieced together from life savings, home-equity credit, credit cards, and loans from his father.” During one particularly difficult period, he said, “What kept me going was just fear that I didn’t know how I’d ever pay back the money.”

Similarly, Tim Westergren, founder of Pandora Radio, persisted with his startup long after others might have called it quits, in large part because he could not face the idea of losing the money invested by his cofounders’ friends or reneging on the $1 million in salary deferrals the company owed its employees, most of them personal friends of the founders. As Tim explained, “I’ve brought everyone into it and can’t turn back. My persistence might look like a virtue, but I have to put myself through this because of all the people I’ve involved who I have ties to.”

Indeed, objective observers might question whether such persistence is virtue or vice, skewing founders’ incentives and possibly leading them to throw away years of their lives, or to throw good money after bad. Some founders refer to taking money from friends and family as “burning the boats,” referring to the legend of the Spanish conquistador Hernando Cortez, who, after arriving in South America with 700 men seeking to conquer the continent for Spain, ordered them to burn their boats so they could not even think of retreat.

One founder said, “Once the money is in, a whole new dynamic is involved. With the relationship at risk, the entrepreneur (the good ones anyway) will move heaven and earth to not lose the investment.

And moving heaven and earth is often what it takes.”

An experienced startup advisor takes a more negative view, comparing “burning the boats” to “entrepreneurial suicide.” He explains, “If one sets oneself up in situations where you must ‘succeed or die,’ then your fundamental motivation must be called into question … Instead of taking prudent risks to maximize your chance for succeeding, you live constantly on the edge in a world of ‘possible success.’ If this is the case, then the business is your ‘addiction’ that you’re asking your friends and family to support. Further, founders and entrepreneurs should have a ‘safe haven’ if they are to have any hope to survive the rigors of the startup company lifestyle. Where do you go for physical/psychic nourishment and comfort when the world is crashing in on you? Family serves this purpose often and best. ‘Burning your boats’ undermines this support structure and thus is setting oneself up for failure.”

For other founders, taking money from friends and family may make them more risk-averse than they might otherwise have been, which can result in a lower exit value. An experienced investor explained, “When an entrepreneur has all of their own personal wealth or their family’s wealth tied up in a deal, they are more likely to be risk-averse and more likely to sell out at a smaller number.”

Founders who prefer a higher-probability small exit to a lower-probability large exit would see this as a good thing. Although the effect of taking money from friends and family will differ depending on the founders involved and the specifics of the situation, friends-and-family investors introduce a more emotional element to the business as it moves forward, regardless of whether that heighted emotion is beneficial or detrimental to the founder and the startup.

B2B CFO®

Free Discovery AnalysisTM

Fill out the form to receive your
Free Discovery AnalysisTM (a $1600 value)