by Asheesh Advani

Learn the basics of raising small business capital from family and friends.

Money from relatives and friends can supplement the business financing you're receiving from other sources -- or even fill a critical gap in starting up your business. Getting friends and family involved in business financing is not uncommon -- nearly one in ten Americans reports a loan outstanding to a relative or friend. This is not surprising, as both you and your family member or friend can stand to benefit from the deal.

Here's what you need to know before you launch into a sales pitch: the basics of private financing, how to present your proposal, and steps to formalize the deal.

Making it Work for Everyone

Raising money from family or friends may seem straightforward: they do something nice for you, and you owe money to somebody who is understanding. However, getting private money has even more advantages for both sides -- though certainly you should tread lightly when making your personal relationships financial.

Advantages for You, the Business Owner

Raising money from family and friends has a number of advantages, especially as compared to other financing alternatives.

• Private money may be available when other money is not. If you've already maxed out your personal sources of cash, but don't have the collateral or revenue to attract bank or professional equity financing, the advantage of private money is obvious: It's your best, and sometimes only, source of start-up capital.
• Private loans may be cheaper than other sources. Family and friends, unlike banks, credit card companies, or even microlenders, are typically not out to make money off the deal. You could end up paying zero interest or interest at below the market rate.
• Private loans offer flexibility. Loans from banks and other institutions are nearly always standardized, but private lending is flexible: You can both set up a customized repayment plan (for example, a six-month grace period followed by 12 months of interest-only payments, followed by a graduated payment schedule for 36 months) and adjust your repayment schedule if your business hits a bump.
• Private money represents validation from key supporters. The start-up phase of a new business is a very stressful time, and having someone you know express his or her belief in you and your idea by writing a check can mean a lot.
• Private money requires less work than other sources of equity capital. You don't have to sell yourself nearly as hard to people who already know and trust you, and this can serve as a dry run for later attempts to secure professional equity financing.

Advantages for Your Lender

You needn't see yourself as preying on the charitable instincts of your family and friends. They also benefit in several ways from investing in your business.

• Investing in you can satisfy your investor's altruistic motives. Those closest to you might help finance your business because they have an unselfish desire to support you and want to see you succeed.
• Investing in you can satisfy your investor's self-interest. Your investor can make money from investing in you -- often, more than they might get from a comparable investment in a savings account or CD. Alternately, they might enjoy the thrill of getting involved with a successful business.

Special Considerations When Mixing Money and Relationships

Of course, there are potential pitfalls and hassles that come with mixing money and relationships. Family members may feel that you "owe them one." Or, you may not like having some lenders or investors watching your every move, then criticizing your new car or family vacation. And, not every lender will be sympathetic as you try to explain your need to reschedule or skip a payment.

For the most part, these are issues that can and should be dealt with in advance. Make the arrangement as professional as possible. That way, your private lender or investor will treat this as business, not a personal arrangement. You can, for example, offer collateral to secure your friend or family member's loan. And, you should agree on clear and definite terms for any loan, including payment dates, interest rate, and penalties, if any. If your friends or family make equity investments, you might agree to give them a right to share the proceeds from the business's assets if it's sold.

How to Ask Friends and Family for Financial Support

The biggest hurdle preventing many entrepreneurs from getting private financing is simply the fear of asking. You can overcome this fear with a combination of careful preparation and choosing a time and place that makes you and your prospective lender or investor comfortable. 

Before actually asking for the loan or investment, plan out how you'll approach your friend or family member.