Seed Capital from Friends and Family

You have a great idea but you need more cash than you have in your account. You don’t have a proven track record and potential investors are not giving you a chance. Your options are limited to friends, family and a small local network. You need to sell your idea, but you don’t want to over-sell your friends and family. You need to provide a superior return to your investors, but you also need to retain control and protect your own opportunity for return. Where do you start?

The place to start is a comprehensive business plan. A sophisticated investor would require a business plan. You owe your friends the same level of diligence. A plan enables your backer to evaluate both your knowledge of the business and the realistic prospect of an acceptable return. If you take their cash without full and open disclosure, you are very likely to damage your relationship. 

There may be a cost associated with building a plan, but it is money well spent. The risk to your relationships is real. You need the plan to prove to yourself that you understand the venture and you need the plan to demonstrate your understanding to your backers.

The other necessary cost associated with bringing in a financial backer is the cost of documenting the deal. A typical deal would have the investor providing both a loan to the company and an equity investment in the company. The loan gives the investor a preference on return of capital and the equity gives them an opportunity for a great return. Limiting the equity also makes it easier for you to maintain control.

A third party adviser is the best way to safeguard against future hard feelings. You will need a lawyer to get the documents right, but you need an adviser who can coach you on reaching a fair deal. The adviser who helps with your business plan may very well be useful in helping your backers understand the plan. They may also be the best source of ideas for structuring debt and equity. Whether it’s a consultant who prepares business plans, a lawyer with a good financial background or a CPA, the involvement of a rational third party will prove invaluable.

If you have a choice between a family member with a willingness to bet on you as an individual, and an investor who has knowledge and experience in a similar business, go for the latter. Someone who has experienced the pitfalls will help you avoid the pitfalls.  This investor will likely sit on your board and may even fill a management role. Obviously, that experience comes with a cost. You may need to negotiate to keep the cost reasonable, but you will benefit greatly from their knowledge and experience.