For small and privately run companies, raising money from family and friends is often a necessary yet least preferred way of financing growth. Alysoun Stewart, director of growth and strategic services at Grant Thornton, says, ‘When companies raise funds from friends and family, it really is a case of the lender of last convenience. It normally happens when a company is going through its first funding round, when there are no established revenue streams, or they have just started to build critical mass.’

Going to family and friends for funds has long been the usual route for start-ups, as banks are unlikely to consider lending to those without track records and reliable cash flows. Statistics from across the pond back this up, where around 95 per cent of start-ups in the US are funded by three main sources of capital – the entrepreneurs’ own funds, cash from family and funds from friends.

Increasingly, however, medium-sized companies are looking closer to home for investment, proving it’s not just an option for firms that can’t get a bank loan or other outside investment. Many budding entrepreneurs turn to loans from friends because they see it as the least expensive and least time-consuming way to raise money.

To start with, unlike a bank, your nearest and dearest are unlikely to demand extortionate levels of interest. Secondly – and in marked contrast to banks and outside investors – they probably won’t want to scrutinise a detailed business plan and, in most cases, when they are just lending money and not taking a seat on your board they will let you get on and run the business. Lastly, they are the most likely investors to succumb to your pleas and be persuaded by your enthusiasm! This probably won’t cut as much ice with business angels or hard-nosed City backers.

The personal touch

But there are numerous practical disadvantages to borrowing money, or raising new equity, from those you know all too well.

Chief among them are fraught and ruined personal relationships. If you approach friends and family, make sure you show plenty of tact, advise them of the risks, and if you win them round as equity investors, make sure they only invest money that they can afford to lose. Remember, friends and family will often fund you because they believe in you as a person, and that personal angle can all too easily override any business uncertainty. If they are putting money into the company for equity – rather than a loan – make sure they realise their stake could become worthless if you fail.

The worst-case scenario should be made clear from the outset. If they don’t understand that your company could go to the wall for reasons completely out of your control, they don’t belong in the world of high-risk investment. The golden rule is to manage expectations.

Standards and agreements

‘Raising money from family and friends is terribly tricky,’ argues Clare Grayston, corporate finance lawyer at Lewis Silkin, ‘and it has got to be a very grown-up process. It’s like putting all your assets in your spouse’s name to avoid creditors, except you’re more likely to get divorced than go bankrupt!’

When it comes to loans from people you know, zero interest terms and informal arrangements are appealing, but with relationships at stake, professionalism and formal processes can protect both parties. To walk the emotional tightrope successfully, it is vital that you put the loan agreement in writing and treat it like any other.

Even if your friend or family member offers a no-interest deal, set the loan up to pay them whatever the going interest rate is anyway. This protects both parties for several reasons. Let’s say Uncle John wants his money back all in one slug for a holiday? Then the agreement should stipulate how the money is to be returned.

Terms and conditions

It is important to agree at the outset whether the money you are being lent allows the investor shares in your company or is simply a loan.

‘A big mistake many companies make is that they fail to formalise the funding arrangement with friends or family,’ believes Stewart. ‘Whether it’s a shareholder’s agreement or a loan agreement, it doesn’t have to be complicated. You just really need to think through the parameters, such as what the transfer of pre-emption rights will be, whether the shareholders have voting rights, whether they will have preference shares, and so on. Typically, if family and friends put the money in as equity, they won’t have voting rights but they can if they wish, so it’s essentially a quasi-loan.’

Failure to follow professional standards when structuring and documenting deals with friends and family can come back to haunt you if your business is successful, with disputes over repayments and share stakes likely to surface. If your company grows to the point where it can credibly approach banks and larger investors, they will want to comb through your books, ascertain the level of financial discipline and check out your shareholder structure. That could be complicated without proper agreements and reporting in place.

One big downside to borrowing from friends and family is that they may lack the business experience, contacts and nous of professional investors. Or, worse still, they are unaware they lack expertise, thinking they know it all and want to interfere in how you run the business.

‘Imagine your sibling has been successful in business and raised a lot of money, says Grayston. ‘He becomes an investor in your business and suddenly he’s a know-it-all, but you feel you can’t say anything because he’s your brother!

‘And what happens if you want to expand the firm, but he wants to exit? All reasons why you really should put a shareholders’ agreement in place – it could be as little as one side of A4 but it will protect everyone. Include agreement on principles, your exit ideals (remember, buyers might be put off if a personal loan lacks proper records), what you are looking for over a five-year timescale, and also resolve debate over the future issue of shares.’

Such agreements don’t come cheap. Expect to pay a legal professional between £3,000 and £8,000 to get everything down in writing.

Grayston points out that friends and family funding is extremely common for small firms looking to float, particularly on AIM. ‘Many of the companies coming to AIM are small and banks won’t lend them all the expansion capital that they need, so friends and family are vital alternative avenues of funding. However, bear in mind, if you are considering this before you float, these private investors often come in at a discounted share price. Your broker will probably say the quid pro quo is that they should be locked in for a set period, but sometimes your friends or family won’t want their cash to be so tied up.’

Case study: TIMESTRIP

AIM-quoted Timestrip, a marketer of label technology that accurately measures lapsed time, is a great example of friends-driven funding working very successfully.

Joint-CEO Paul Freedman says, ‘As a private company, we raised money four times, over a three-and-a-half-year period. And before our initial flotation in 2005 (where Timestrip reversed into AIM shell Internet Music an
d Media), virtually all our shareholder base was acquaintances. Around 70 per cent were friends and family, with the remaining 30 per cent of investors introduced to us by people that we already knew.

‘From the start, we didn’t want to rely on money from our friends,’ he concedes. ‘We didn’t want to let them invest in that first funding round until we raised a minimum of capital ourselves. The last thing we wanted was all our risky initial capital to come from friends and family. After that, we said to them, “Look, we’ve got a very exciting business here and we would like you to make some money.” But we also told them if they were going to invest money, they should imagine they’ve already lost it, because it was high risk.’

As for the company’s investment agreements, he says, ‘These were conducted as professionally as we could. We had articles of association, which you have to have, and these gave our friends as good a protection as any other investors.’

Many of these friends invested more money in subsequent funding rounds. ‘Our friends are all locked in and will continue to be so for a while, although there has been a cultural shift post-float. Before joining the stock market, we were able to email friends and family about progress, but we cannot do that as a public company, and many of them miss it.’