According to research, 36% of funding for startups comes from family and friends. Furthermore, family and friends invest on average $23,000 in a startup. This presentation will explore the complexities of accepting this money in the form of equity or a loan, how to minimize friction once the investment is made, and one potential tax issue related to paying interest.

1. Raising Money from
friends & Family:
Loans or Equity?

2. According to research, 36% of funding for startups comes
from family and friends. Furthermore, family and friends
invest on average $23,000 in a startup.

3. Equity (Stock) or a
Promissory Note?
The idea of giving stock to
family and friends is enticing. If
the business does great, you
will have the opportunity not
only to make yourself rich, but
also enable your supporters to
share in your success.

4. Example
Even a little bit of stock received very
early on in a company’s life can make
an investor rich. I remember a story
about a painter that was decorating
Facebook’s first office and received
payment in stock. In the version of
the story that I heard, the
painter became a millionaire
as a result of a few
days of work.

5. What if the Company does poorly?
Money invested in stock doesn’t have to paid back if the
company goes bankrupt. A business owner does not
necessarily have to spend years paying back investors, as
they might with debt.

6. The Three Big
Problems
With The Equity
Approach To Funding
A Business

7. Problem 1
Most Companies Aren’t
Inherently Designed To Be The
Next Facebook or Groupon
A successful outcome doesn’t necessarily lead to a
situation where friends and family can turn their stock
into big financial gains. Even if a company is doing
well, for example producing a half a million in profits
per year, your family and friends may not be able to
turn their stock into cash.

8. Problem 2
Friends and Family that own
Stock are Minority Owners
Even if friends and family own only a small
sliver of a company, they may feel that they
have the right to weigh in on company decisions.
Family get togethers can potentially feel like a
business meeting in which the owner must
listen to hours of unwanted advice.

9. Problem 3
There is the Question
of Valuation
How much is your company worth? Early stage companies are very
difficult to value. The founders of companies often have unrealistic
expectations, which tend to get re-adjusted during the process of
raising money from professional investors and financial institutions.

10. The Alternative To Equity: A Loan
While a loan is not as sexy as equity, it does not have the problems
mentioned above. If the company is successful, friends and family
will get back what they invest and earn interest. Even if the
business doesn’t work out in the long run, a business owner may
be able to pay back some or all the money.

11. The Right Way to
Borrow Money
When borrowing money, there are a few
key question that you need to decide:
1. Personal or Business Loan
2. What Interest Rate and for how
long?
3. How should the Loan be
documented and the Loan Payment
s be handled?

12. 2.
Personal or
Business Loan?
It can be much simpler and less expensive to take money as
a personal loan, rather than borrowing money as a company.
However, taking the loan as company provides some
separation between personal finances and the business.

13. 2.
What Interest Rate?
An interest free loan can be a very bad
idea, even if the lenders don’t care
about receiving a positive return on
their money. The problem is the IRS
might take the opinion that the loan is
in fact a gift from the borrower, rather
than an investment.

14. The IRS publishes an
index of Applicable
Federal Rates,
Which are the minimum rates they
expect on loans based on the term
of the loan. Applicable Federal
Rates are updated monthly on the
IRS website.

15. A Market Based Approach
There are firms, such as Prosper, that provide personal loans
for business purposes. The average interest rate changed by
these firms is around 15% per year. As the purpose of a
friends and family loan is to help a person start a business,
the loan rate should well be below these market rates.

16. What should be the
Length of a Loan?
It often takes businesses three to five
years to start turning a profit. The longer
the loan, the smaller the loan payments,
and the easier it will be for the business to
succeed during those first few critical
years. If putting the business in a good
financial position to survive is the primary
concern, a loan of 10 years or longer
makes sense.

17. What should be the
Length of a Loan?
However, most startups don’t last 10
years. Many businesses last only 3, 4
or 5 years. A loan of 3 to 5 years
represents a compromise between
how long new startups tends to
last and putting the business
in the best position succeed.

18. 3.
How should the loan
be documented
and payments
handled?

19. The Issues
A promissory note will provide clarity
to both sides on the following issues:
1. How much is being borrowed?
2. At what interest rate?
3. When will payments be made?
4. What are the consequences for non-payment?

20. Why a Promissory note?
Without it, there is a much greater opportunity for
misunderstandings and disagreements later on.
While there are a plethora of free promissory notes available
online, we highly recommend that using a paid service,
such as ZimpleMoney or TrustLeaf for personal loans and
InvestNextdoor for business loans.

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