Getting the family to invest in your business - 1993 Money Management Guide

Black Enterprise, Oct, 1993 by Patricia M. Carey

Five years ago, when Babette Peyton of Chicago founded Peyton Elevator Co., an elevator installation, repair and inspection company, she bypassed banks and appealed to her mother, Rosette Peyton, for start-up capital. Rosette loaned her $17,000 from savings and $30,000 from a home-equity loan. Over the next five years, she chipped in an additional $100,000 from her school-teacher's salary.

Today, the young company is still not profitable (although Babette predicts it will be this year), and she has repaid Rosette only $1,500 of the $147,000 she owes. But Rosette's faith in her daughter remains unshaken. "I believe very strongly in Babette," she says. "I know she will succeed."

In today's brutal credit environment, there's no substitute for that kind of faith. As banks and government regulators tighten the lending screws, more and more entrepreneurs are turning to friends and family for start-up capital. The advantages are obvious: Personal relations make sympathetic bankers, repayment terms are usually flexible and red tape is minimal.

Borrowing from friends and family is a particularly popular option among African-Americans, who often lack easy access to other sources of cash. In a recent study by the Kessler Exchange of Northridge, Calif., 36% of African-American small-business owners sought financing from friends and family compared with just 24% of whites, 29% of Asian-Americans and 23% of Hispanics.

Yet borrowing from personal relations carries enormous risks. Statistics show that most small businesses fail, often leaving behind substantial debts. If you can't repay a financial institution, your credit rating suffers. If you can't repay Aunt Agnes or Cousin Tyler, the consequences can be far more personal - and painful.

Even if a business flourishes, personal relationships can suffer. What if a relative helps you out when you're a struggling entrepreneur? When the company strikes it rich, the family member may expect a piece of the action. According to A. David Silver, president of ADS Financial Services Inc., a Santa Fe, N.M., investment banking firm, "The problems of success [can be] even worse than the problems of failure because of the greed factor." That is, unless you take the proper precautions.

Small-business financing experts say problems often stem from agreements that are unwritten, incomplete or vaguely worded. "People want to demonstrate their level of trust by allowing these transactions to be very informal," says Thomas D. Davidow, a principal of Genus Resources Inc., a Needham, Mass., family business consultancy. "But the lack of formality enhances the risk. People don't realize until later that they have very different expectations about what's going to happen."

Does that mean you shouldn't borrow from friends and family? No. But it means you should take particular care in how you structure these arrangements. Think of it as giving your homegrown financier the same kind of attention you would a bank lending officer or a wealthy stranger.

Provide A Business Plan

If your friend or relative is undecided about financing you, a good business plan can tip the decision in your favor. Be sure to spell out what you're going to do with his or her investment and how you're going to make enough money to pay it back. "Formalize the business so that you're making decisions based on real numbers, not intuition," says Don A. Schwerzler, a principal of the Family Business Institute in Atlanta.

A business plan improves your chance of success. It forces you to articulate a long-term strategy, and makes it easier to identify potential trouble spots. Geoffrey Kessler, founder of the Kessler Exchange, suggests taking the plan to local bankers even if you're sure they won't lend you money. Why? Because conservative bankers are very good at spotting flaws. "If you're only talking to friends and relatives, you're not getting objective advice that might keep you out of trouble," Kessler advises. If you've never written a business plan, read a book on the subject or contact your local Small Business Administration (SBA) center for help.

Structure The Investment

Once your investor has agreed to come up with the cash, you have to decide on the structure of the investment At one extreme is a straight loan that will be paid back with interest At the other is a straight equity investment, where the investor's cash buys a piece of the new company.

Between these two options, there are endless variations. You might, for example, give a lender warrants entitling him or her to buy shares in your new company at a set price.

Friends or family members will often feel uncomfortable hashing out this issue. Typically, they are backing you for personal reasons, and may feel that a discussion of financial terms indicates a lack of trust or generosity. Therefore, you should bring k up yourself. If you air this issue at the beginning, your investor may be grateful later on.

Consider this: In 1989, when Pierce and Rosalind Grant-Clifton of Chicago told their friends William and Anne Tucker they wanted to open a temporary employment agency, the Tuckers immediately offered to lend them $15,000. "I had the money available," remembers Anne, who is president and CEO of a $5-million nurses temp agency. "I knew Rosalind's experience, and I had no doubt she would be successful."