Q: What are the potential pitfalls of borrowing startup capital from friends and family?

A: Every new business needs an influx of cash to start and grow. While I have been a partner in a couple of businesses that fortunately generated enough cash flow through revenue to manage growth, most require people to write some checks.

Obviously, the first bank accounts tapped belong to owners, and immediately from there to the owner’s credit potential with traditional lenders.

When these sources begin to dry up, many people look to friends and family, a source with its own set of challenges.

First, depending on how much cash the business needs, you must be associated with people who have that much to lend. In decades of advising early-stage businesses, the vast majority of entrepreneurs know few, if any, people with the funds to write such checks.

In those cases where a relationship exists, the business owner must consider unique “costs of capital.”

When dealing with a bank, or a seasoned investor, the terms center on the interest rate and the length of repayment schedule. In dealing with friends or family, let’s say you have an affluent uncle who worked as an engineer.

While he may have the funds and be willing to give you a loan at a reasonable rate, his money may also come with expectations that go beyond a strictly business arrangement. Plus, you must consider the social costs of both success and failure.

If your failure means you default on the loan, you can see how that will be bad. If you go on to spectacular success, the uncle may feel cheated at only getting his small interest growth on the loan.

Perhaps a better way to fund would be to network your way, through friends and family, to businesspeople interested in angel investing.

In addition to getting an influx of cash, you could choose to take money from people who bring some perspective and savvy to the business.

As the amount of investment increases, angels will more likely want equity in your business, but the value addition of their expertise may make that much more palatable than alienating your mother’s brother.

 

Mike Porter is a faculty member in the marketing department at the University of St. Thomas Opus College of Business.