Thanksgiving is a wonderful time of year. It’s a time when families and friends get together to just chill. There’s not the pressure of gifts or the rush of multiple, conflicting parties for 3 weeks like there is during Christmas. It’s cozy and relaxing.
Unless you went into business with someone at the dinner table and it’s not going so well. Or even worse, if you lent money to someone and they aren’t paying you back, even though they just posted wonderful pictures of their latest dreamy vacation to their Instagram.
In a previous article, I wrote about the pros and cons of taking money from investors. How there are always strings attached as you invite more people into the business and how the “silent partners” never are.
Let’s explore the other side of the equation. What if you’re the investor or business partner and you’re asked to invest in the business of a family or friend? Or to become a partner in the business of someone you’re close with.
Going into business with someone you know and can trust has its advantages. For starters, you know and trust them. You potentially know their strengths and weaknesses and have seen them in different situations so you have a good guess on how they’d react to a given situation or what type of manager they’d be. You’ve got a pretty good idea they aren’t selfish thieves. So you’re already on first base.
Your friend may be the perfect complement to you and just who you need to go into business with. Sometimes going into business with someone you already know is the best way to do it. What could be better than working with someone you really care about? A lot of great businesses were started by friends who got talking about ideas and ways to solves problems. I’ve had a few businesses start over late-night talks with friends over pizza.
Someone who knows you is much more likely to loan you money. After all, they know and trust you. That’s a blessing and a curse. In a video I talked about the funding ecosystem and how the first step in funding a new company is often the 3 F’s – friends, family, and fools. That early money may be the easiest to get, but it’s also the riskiest for the investor.
A new company without much traction and maybe not even a product is uncertain. The assumptions haven’t been tested and the founders may not even know what assumptions to test or that they should even be thinking about assumptions. (I’ve found that founders don’t do a lot of introspection and evaluate where they may be going wrong because they’re so excited about changing the world. That same optimism that lead them to start, can also be a blind spot.) They haven’t yet taken the time to take the vital first step when starting a company – finding out if anyone wants your product.
The new company may be riskier, but family and friends are often willing to overlook that for 2 reasons: 1) the initial investment amounts are often small (or should be) and 2) they believe in you. Investment rounds usually start small and get larger as the company grows and needs more cash. That’s good for the family and friends because they have risked less of their money.
More importantly, however, is that they believe in you. They’re more willing to overlook flaws in the business plan and may not even do a lot of due diligence to begin with. They’re not investing in the business idea, they’re investing in you. That may make you feel warm and fuzzy but it can cause big problems down the road.
If your business is one of the 20% that doesn’t fail in the first 5 years, then that’s great. You don’t have to worry about the downsides of working with family and friends. However, the odds are not forever in your favor.
If the business fails, that will undoubtedly put a strain on your relationship. One that may never recover if you don’t set things up the correct way.
If you’ve decided to go into business with family or friends or to accept investment money from them, that’s great. It could be the best decision you make in your business. However, be sure to protect yourself. Even take some extra steps you wouldn’t normally take with other investors because there’s more than just money at stake. There are close relationships that need to be protected. Taking the attitude that since you already know each other so a handshake is good enough, will surely spell trouble, even if the company does well. Maybe especially if the company does well!
It’s very important that everything is spelled out before you start. Outline in writing what each of you is bringing to the table and what happens if the company doesn’t work out. Answer important questions like, who keeps the domain name or the office mascot if you close the company. Also, think about how profits are shared and how will your roles change as the company grows. For example, if the company is hugely successful, what happens if one of you wants to retire and the other want to keep growing the company? It happens more often than you’d think. It causes problems because now one partner is working hard and the other is skiing and they’re being paid the same.
Memories get real fuzzy as time goes on. Everyone remembers things differently a couple of years down the road. Long ago I came up with a really good domain name for an investing website. I went into partnership with a friend and we started building out this website. After a couple of years, we both moved on to other things. When I approached him on transferring the domain name to my registrar, he said, “Wait. That’s my domain. I thought of it, so I’m going to keep it.” I’m pretty sure I thought of it, but who knows, maybe it’s my memory that’s fuzzy and not his. Memories are unreliable. Putting that down on paper sure would have helped.
Have a contract. Spell everything out. I mean everything. The more you can put into a contract the better. Don’t be put off by the fact that you’re making things so official. It’s natural to think of a contract being necessary for only people you don’t trust.
A wealthy friend of mine once asked his soon to be bride to sign a prenup. I asked him if she felt that he didn’t trust him. His response was interesting. He said that by having a prenup it made finances a non-issue in their relationship. They didn’t have to rely on memory or trust because it was all written out in the agreement so they could focus on the rest of their marriage.
It’s the same with a business. Spell it all out in a contract so you don’t have to worry about it because if the time comes when you do have to worry about it, it will be much too late to write a contact. There won’t be anything you can do about it and you could easily get the short end of the stick. Or maybe your partner gets the short end. Either way, no one will be happy.
In addition to a contract, require them to do their due diligence and sign a statement that they have done so. The statement should outline the risks and notify the investor that they could lose all of their money. This can help protect your relationship by encouraging them to invest wisely and not just give you money out of love for you. While it may sound incredible that they would invest without asking too many questions because you’re friends, it will surely come back to bite you if the business doesn’t work out.
For more about investing, read Should you take investor money?
CFO & former Wall Street analyst helping your reach financial independence.
Download my eBook “20 Ideas to Earn Extra Money from Home.”
Take my financial planner course to learn the secret to building wealth that they never taught you in school