Startup Funding From Friends and Family: Best or Worst Idea Ever?

• Startups need funding to be successful.
• Experts agree that you should avoid asking friends and family for funding.
• If you do ask, be cautious and professional.

Online funding management systems have made it popular and convenient for entrepreneurs to ask for and collect startup funds from family and friends.

Hundreds of now successful young businesses got their early boost from benevolent relatives and friends.

Whether startups use sites like Kickstarter and GoFundMe, or whether owners approach family and friends in person, it's become commonplace and even acceptable to solicit relatives and buddies for money to bootstrap a business. In fact, according to financial services guru InDinero, the friends and family source of funding now makes up an average of 40% of startup money. Experts stress that you should exhaust all other sources before asking for or even allowing contributions from personal connections, but that may not stop some would-be entrepreneurs.

There are significant risks associated with asking for and taking money from these sources, however.

The potential hazards are both personal and business-related. Here are some reasons not to ask friends and family to help fund your startup.

You place your personal relationships at risk

Startups are inherently risky business. In many cases, when funding is still to be obtained for prototyping and testing the market, proof of concept hasn't yet occurred. As an entrepreneur, you understand that the business is a venture, not a guarantee. 

Your relatives and friends, who may not be business-savvy themselves, probably don't fully realize the risk they are taking by investing in your startup. You can tell them. You can sit down with them and emphasize that they might never see that money again. However, they may be motivated by the idea that they could make a profit, by their love for you, or by their trust in you that you are clever and you know what you're doing. These are all factors that can prevent them from assessing the risk objectively and, if things don't work out, could make their loss very hard to bear.

When the day comes that you have to tell them their money is gone, they may not remember the warnings you gave them. However, they will remember you taking their money, and they will clearly remember you not giving it back. That makes for some very awkward family gatherings for the rest of your life.

You don't know where the money is coming from

When you get a bank loan or an investment from a venture capitalist, you have some idea that the money is coming from a fund set aside for loans and that a certain level of risk is assumed.

When you get money from friends and family, you don't know where the money is coming from. If you did know, you might think twice before asking your mom or uncle or best friend for money to gamble on your business idea.

For all you know, that money could be coming from your dad's retirement account, which he emptied out because you're his son and can do no wrong. Your best friend might have secretly liquidated his kid's college fund to give you for your startup. There's a reason why financial managers set boundaries for people who want to invest in the stock market. They don't want naïve investors mortgaging their house and going broke. You, too, need to establish parameters around the funding you are seeking from family and friends.

The right way to ask for funding from friends and family

Of course, with shows like "Shark Tank" hyping the generosity of friends and family who support entrepreneurs, or if you don't qualify for certain types of financing, you might have to turn to friends and family. If that's the case, there is a right way to get funding without jeopardizing so much.

1. Set limits. Set a cap for any single investor who is not a professional investor. For instance, don't allow anyone to invest more than $1,000. This helps prevent magnanimous donations from friends and family who may not be able to truly afford it.  
   
   
2. Make it official. Make every contribution official, whether it's $25 or $500. Making it official means signing paperwork, which you should have a lawyer write up, or there are online resources and templates that can help you create a record of the loan. Everyone should have a record of the funds they provided for your startup, as well as details about interest, repayment, etc. 
   
   
3. Provide a written prospectus of your startup. When you take the time to prepare a written prospectus, you can share it with those who are thinking of investing in your startup. A written prospectus ensures that everyone gets the same information, plus it shows that you were open and forthcoming regarding the business details and the risks involved.
   
   
4. Stay professional. Always answer people's questions, and be honest about how their investment is faring. Give them the same terms that you have provided to other outside investors, if there are any.

5. Don't be shy. If you are going to ask for financing, make sure you ask for enough. While it sounds counterintuitive, going the friends-and-family route requires that you be direct and transparent. Be clear about how much you need to launch your business.

Before you risk your personal relationships, make sure you explore all other avenues. As an entrepreneur, you should be able to think creatively about finding alternative means to fund your startup.