Financing Entrepreneurial Ventures, Part 2

Stephen DeAngelis

July 6, 2011

In yesterday’s post, I discussed a number of avenues available to entrepreneurs seeking capital to start or run their business. In this post, I would like to discuss opportunities and perils associated with obtaining capital from sources closer to home (i.e., friends and family) and why bootstrapping may be the best way to proceed. We’re all aware of the age-old caution that you should never borrow or lend money to friends. Someone once wrote, “Before borrowing money from a friend, decide which you need more.” The underlying assumption for this advice is that relationships matter more than money. Relationships can sour quickly if the money isn’t repaid promptly. Just watch any daytime courtroom reality show like Judge Judy, Judge Joe Brown, or The People’s Court and you’ll see the truth of the adage.

 

Despite that caution, financial relationships are constantly being entered into between friends and family. Sarah E. Needleman writes, “If you’re starting a business on a shoestring budget, you may be inclined to approach the people closest to you for financial assistance. After all, those individuals are generally going to be willing to open their wallets whenever possible. But there can be pitfalls to accepting a financial gift or loan from a relative or friend.” [“Help From Family Has Its Costs,” The Wall Street Journal, 5 June 2011] Needleman opens her article with typical example of what can happen. She writes:

“Since borrowing $8,000 from his older brother and $2,000 from a friend to start a jewelry business, Andres Arango says both relationships have soured. Whenever they communicate, the brother and friend raise the subject of the loan and the progress of his business with a negative tone. ‘The well has been poisoned,’ says Mr. Arango, who launched Muichic, a retail and wholesale business, from his home in Burlington, Vt., in 2009 after getting laid off from a technology company. While the 34-year-old entrepreneur has assured his investors several times that he’s working hard to pay them back, ‘there’s always this underlying tension,’ Mr. Arango says.”

If you feel a compelling need to get money from family and friends, make sure that you do it on a business basis (e.g., draft a business plan, sign contracts, etc.). Even then, Needleman notes, there could be tension. She explains:

“The generosity could create tension if, say, your loved one doesn’t agree with how you are running the business. Or, the arrangement might add to the stress you’re already feeling from trying to build a successful enterprise.”

Alana Muller, president of Fastrac, told Needleman that entrepreneurs shouldn’t “ask family or friends for help just because they’re willing and available.” Muller has probably seen too many of those arrangements go bad. Needleman reports that Fastrac is “a program for helping entrepreneurs start and grow companies that’s offered through the Kaufman Foundation, a nonprofit in Kansas City, Mo.” If you’ve read very much about entrepreneurism, you’re probably very familiar with the Kaufman Foundation’s work. Needleman provides other examples of entrepreneurs who have borrowed money from friends and family and details some of the tensions that have arisen as a result. Needleman notes that personal spending habits are likely to raise tensions. People who have lent someone money would obviously rather see $50 back in their pocket than the borrower going out to dinner and a movie. On the positive side, Needleman notes that entrepreneurs are doubly motivated to succeed when failure means letting down those you love. Needleman concludes:

“One way to avoid friction or stress when accepting loans from family and friends is to commit to providing periodic status reports on how the business is shaping up, says Ms. Muller. She also recommends setting terms in writing, including how much control the lender will have and when and how the loan will be paid back. ‘You want to establish expectations,’ she says. Another option is to seek financial aid from family or friends that doesn’t involve an actual investment in your business. For instance, Gia Ricci lives and runs a start-up business out of her parents’ home in New York for free.”

For parents wishing to help their children (and who can afford it), outright gifts of money might be better than loans. Rosalind Resnick asserts, “With unemployment still close to double digits and entry-level jobs in short supply, it’s tempting for parents of college graduates—and other struggling twentysomethings—to try to help their adult children start businesses.” [“For You, Graduate, Some Start-Up Capital,” The Wall Street Journal, 7 June 2011]. She writes, “Certainly, there’s nothing wrong with giving your kids the money as a gift—as long as you do it without any expectation of getting it back.” Of course, most parents can’t afford outright gifts of cash; so Resnick talks about parents becoming angel investors. Only half in jest, Resnick notes that parents already have sunk costs in their children. “What better investment can you make in your children’s future,” she asks, “than to set them up in a business that can provide a steady income?” She continues:

“If only life were that simple. The reality, of course, is that most start-up businesses fail within the first few years and parents who ‘double down’ as angel investors risk not only their capital but their relationship with their kids as well. ‘It is important to realize that there is a good chance the investment will not pay off financially and, even if it does, it will likely take longer than you think,’ says Ken Shapiro, a wealth manager at UBS Financial Services Inc. in New York who advises multi-generational family businesses.”

Almost everything I’ve read on this subject agrees with Shapiro’s assessment that risks are high and returns normally take much longer than anticipated (if they materialize at all). Resnick implies that investing in start-up companies holds the same allure of “hitting it big” as the lottery. She asks, “What if you want to serve as an investor in your offspring’s venture—with the opportunity to profit if his or her business becomes the next Facebook Inc., Google Inc. or Yahoo Inc. (all of which were started by college students)?” Resnick knows that children are going to continue to seek help from parents so she offers some advice to parents about how to protect the downside “by entering the venture with your eyes open and a realistic idea of what to expect.” She provides “five tips for making your partnership a productive one.” They are:

1. Get on the same page. Before you write that first check, sit down with your budding entrepreneur and make your expectations clear. If you’re investing significant capital—say, more than $100,000—make sure that your son or daughter understands that it’s an investment (or a loan), not a gift. While you may not be charging interest on the money or demanding venture capital-like returns, make it clear that you’re not looking for a tax write-off, either. …

2. Paper up the deal. No matter how much you love and trust your child, it’s important for both sides to put the terms in writing to prevent misunderstandings down the road. For example, is the money going in as equity or debt? If you’re expecting to be repaid, spell out the term of the loan and interest rate. If you’re looking for an equity stake, be sure to hammer out terms like dilution, voting rights and liquidation preference, says Dave Lavinsky, president of Growthink, a consulting firm in Los Angeles that advises entrepreneurs on new venture development. The last thing you want is to take all the early-stage risk only to see a pack of sharp-dealing venture capitalists walk away with the lion’s share of the proceeds should the company get sold for a big number. …

3. Encourage open and honest communication. If your child, the CEO, is afraid to admit mistakes and come to you with problems, you may find yourself reprising your role as the nagging parent of a teenager who throws his report card in the trash and stubbornly refuses to clean up his room. That’s why Quentin J. Fleming, author of “Keep the Family Baggage Out of the Family Business,” suggests that parents ask themselves if they can honestly treat their kids like adults and allow their children to run the business without unnecessary interference. …

4. Consider playing an advisory role. Unless your child has started a business before, he or she may need more than just your money to get the company off the ground. Especially if you’re a business owner with industry or financial expertise to bring to the table, consider joining the company as an advisor or executive. …

5. Be patient and supportive. Few start-up businesses succeed overnight, and chances are your child’s company will struggle no matter how much planning he or she does and how much advice you dole out. Remember that start-up companies, like young plants, need TLC and resist the urge to lash out at the first-time CEO if he or she makes some rookie mistakes. Be prepared to stand by with your checkbook as well, says Mr. Fleming, the family business expert. ‘Unlike a bank, parents can provide “patient capital” should the business not progress as quickly as planned,’ he says.”

Even when things are put on a purely “business basis,” if the business fails relationships are likely to be permanently affected. It’s human nature. One way of getting by with as little capital as possible is to do a little bootstrapping. “Bootstrapping,” according to Jonathan Moules, “[is] when companies fund growth from their own resources.” [“Use your bootstraps to get up and running,” Financial Times, 7 June 2011] Moules claims that bootstrapping “has become a guiding principle for many entrepreneurs.” He continues:

“Davor Hebel, a partner at Fidelity Growth Partners in London, says: ‘We love bootstrapped entrepreneurs because, as a rule, they demonstrate sophistication, rigor and tenacity. By definition, they tend to grow slower than their funded counterparts and are often built on more solid foundations given their need to be super- efficient from day one.’ Another evangelist for bootstrapping is Harry Clarke. He started his transport technology business, Cobalt, from a portakabin to save money. From here, his team developed Ring Go, a method of paying car parking charges over mobile phones that has since been adopted by more than 100 local authorities across the UK, generating revenues of more than £1m. Despite its rapid growth, Clarke has been able to retain complete control over the brand without a penny of outside funding. He says bootstrapping forces you to have a tight strategic focus, but enables you to make decisions quickly and easily because there are no outside shareholders to answer to.”

Although bootstrapped enterprises grow slower, they are more financially sound (i.e., they have little or no debt) and are forced to follow sound financial practices. In a companion article on bootstrapping, Alex Macpherson, a partner at Octopus Ventures, and Jonathan Yates, author of Freesourcing: How to start a business with no money, were asked what advice they could give to entrepreneurs. [“Ask the experts: Bootstrapping,” Financial Times, 7 June 2011] Macpherson writes:

“● A lack of funding forces an entrepreneur to obsess about customers. Revenue from paying customers is the only available source of funding for most businesses that start today. Acknowledging this early on will guide the entrepreneur to relentlessly focus on building something of value to the customer – and not to be distracted by visionary, or fanciful, products. …

“● Customers can be encouraged to help you cut your costs. By reducing customer acquisition costs by member-get-member marketing, a business can also reduce its requirement for funding, while still growing – endorsement and advocacy by your own customers is an exceptionally powerful tool.

“● A lack of funding can force best practice. Tight financial controls around creditor and debtor management are essential in any business. A reduction in debtor days can often make a significant impact to a business, which in turn may negate the need for funding.

“● Finance is an accelerator and enabler for business. It is not a cure for a poor product or a reluctant customer. If a business requires financing, a chief executive must be honest with himself as to why this need has arisen. The starting point should always be: how do I make this successful without funding?”

Bootstrapping is all about getting cash flow as soon as possible. Anything that detracts from that goal will undermine bootstrapping efforts. Yates writes:

“● Grow organically. Start your business, get paid for the job and use the profit to get more business and modify the offering.

“● Use credit cards. Yes, it’s a form of outside lending but it’s one where you don’t need a business plan – just don’t get caught up with the borrow, borrow, borrow cycle. Know when to stop when it’s not working.

“● Use your savings. It’s your money, your business idea and you believe it, so put your money where your mouth is and invest your savings to make change.

“● Negotiate creative payment terms. Buy the product with a 120-day payment term and sell it as soon as possible, with a 30-day payment term. Put the cash earned in the bank and pay bills only after you have received the money. Pocket the difference and do it again.

“● Ask friends and family. Again, this is a form of outside borrowing but one that is readily accessible. Beware that nepotism can backfire should things not go to plan.

“● Start a business for more than money and the rewards will come. There is no substitute for hard work so start the business with your ingenuity and reinvest the profits to grow the opportunity.”

I’m a lot more attracted to Macpherson’s advice than Yates’. Two of Yates recommendations concern me. His recommendation about using credit cards is alright; but his reasoning is flawed. He says you should use them because “you don’t need a business plan.” Whether you use credit cards or not, you need a business plan. Businesses without plans generally fail. His recommendation about asking friends and family for money also worries me. He seems to ignore most of the downsides of this course of action. Hopefully, the discussion above will give you some pause before moving in this direction. Finding capital for a new business is a tough and, often, unpleasant task. Nevertheless, it is absolutely essential. The best advice I can give you is to be smart about how you do it. Don’t be forced into decisions you will later regret.