Balancing family, financing for entrepreneurs

The saying "never mix friends and family with money," might be as old as currency itself. Even William Shakespeare alluded to the dangers of mixing friends and family with money in the play Hamlet, stating "neither a borrower nor lender be. For loans oft loses both itself and friend."

But, for an entrepreneur who has tapped his or her own personal resources and can't get a good rate on a bank loan, borrowing from friends or family members might be the only option to getting the business off the ground.

Informal investments - money from family, friends, neighbors and colleagues - accounted for $600 billion worldwide, according to a study by the Global Entrepreneurship Monitor, which tracked entrepreneur financing in 42 nations.

Compare that to the $37.3 billion of classic venture capital that was invested in 11,066 companies during that same year. When combined with the money provided by the entrepreneur, the money given by informal investments equals 3.9 percent of the gross domestic product of the 42 nations studied.

"Informal investment is an essential ingredient of an entrepreneurial nation," according to the report. "A nation that wants an environment in which entrepreneurs thrive and prosper must first and foremost have policies that facilitate investment by (family and friends), because nearly every new venture must have it."

In the United States, which is considered to be the preeminent venture capital nation in the world, fewer than one in 10,000 new companies has venture capital in hand at the outset and fewer than one in 1,000 businesses ever has venture capital at any time during its existence.

"Even in the United States, a would-be entrepreneur has a greater chance of winning a million dollars or more in a lottery than getting venture capital," according to the Global Entrepreneurship Monitor.

Bring the family to the table

The key to borrowing from loved ones without making them hate you is to lay everything on the table - all the risks, the business plan, expectations for the business and the rewards, according to local experts.

Make sure both parties understand the terms of the investment - whether it is a loan or a gift - and the deal, including the repayment schedule. It should be fair to both parties, said Ric Denton, chairman of the local SCORE office.

"This age old adage that you should not do business with friends or family often becomes true because they are so afraid to be upfront before they get into the transaction," said David McDermott, attorney with Colorado Springs-based Susemihl, McDermott and Cowen P.C.

Just because the investors might have known the entrepreneur since he or she was in diapers, doesn't mean that the two parties should treat the business deal like any other.

The most common mistake people make when entering into a business deal with friends and family is that people make too many assumptions and don't record the details of the deal, McDermott said.

In addition to detailing a repayment schedule and what will happen if the loan isn't repaid on time, people also should write down what role, if any, the lenders will play in operating the company.

"It pays to get a good lawyer," said. Tad Goodenbour, a partner with BKD LLP. "It's a pretty simple documentation. You may have to pay $200 on the forefront, but if it does go bad on the back end that's damn cheap insurance."

When dealing with family or friends, the emotional aspects of the relationship should be taken into consideration, said Gary Neuger, a Colorado Springs psychologist. If the lender is a bossy or nosy mother-in-law, it might not be the best idea to bring that relationship into the business.

If the borrower is a son who still hasn't repaid his car loan from 10 year prior, it might not be smart to make a larger and riskier loan to him.

"You have to decide if it is worth the potential of going to small claims court if things don't work out," said Chris Chavez, regional spokesman with the Small Business Administration.

In addition to the emotional risks, lenders should be aware about the financial risks they are taking.

"Sometimes the bells and whistles ought to be going off in your head that that particular family member has come to you for the loan. It probably means they had difficulty getting a loan from a bank," McDermott said. "That should be a warning sign that this is a riskier loan. There is a reason he's coming to family."

Entrepreneurs also should expect to put their own neck out on the line for their business. Most potential business owners usually have to put up about two-thirds of the initial capital needed to launch a business, according the Global Entrepreneurship Monitor.

Payback

The median expected payback time for investments is two years and strangers expect higher returns on their investments than parents, according to the Global Entrepreneurship Monitor 2006 report.

Thirty-four percent of informal investors expect they will not receive any of their investment back and 5 percent expect they will receive 20 or more times the original investment.