Things to Consider Before Asking Friends and Family to Invest In Your Venture

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Editor’s Note: Charles Moldow is a general partner at Foundation Capital, focusing on consumer Internet companies. He was previously a founding executive at TellMe Networks and at @Home.

Friends and family can be an essential source of funding for fledgling entrepreneurs. Sometimes, they are the only source. But before you ask for funding, you have to ask yourself some tough questions, and one in particular:

“What happens if I lose their money?”

It happens all the time. It happened to me, and it forced me to learn hard lessons that can hopefully prevent other entrepreneurs from making the same mistakes. Before I became a venture capitalist, I was an entrepreneur with a new endeavor that I firmly believed in. I was wildly optimistic about the future and was eager to bring in friends and family to help get the company off the ground. I dreamed of the day when the company would become successful and make a big profit for those closest to me.

And then I lost their money. All of their money.

Years later, I ended up on the flip side of the equation, investing in a company run by my child’s godfather. The investment was strategic from a business perspective, but the decision to invest was also motivated by my personal relationship with the CEO. Later, with the company struggling, I had to lead the board in the incredibly difficult decision to shut down the company. To make matters worse, the company’s closure was announced while the CEO and I were vacationing together with our families. Needless to say, there were some very awkward silences around the dinner table.

Of course, just because I had a few bad experiences with the friends and family financing plan doesn’t mean that you will too. There is still great value in soliciting support from the people who you know and trust the most. Let’s face it: early-stage financings are the most challenging to secure, and friends and family money is usually the easiest to find.

But before making the leap, it is worth following a few simple guidelines:

  • Not all capital is created equal.

True friends and family money is what I call “love money.” It’s money that they invest because they support and love you, with any possible future return seen merely as a nice bonus. It’s important for everyone involved to understand that there is a reasonably high likelihood that their money is gone for good. If this is the construct, the dynamic is healthy. But, when a friend or family member’s primary reason for investing is to see a return, things can become problematic.

  • Less is more.

Giving any investor an overly large stake in the company for an inconsequential amount of money could cost you down the line, especially when you are trying to raise new funds in later rounds. But this applies especially to relatives who are often unsophisticated investors. In these cases, owning a large chunk of stock may put them on shaky and unfamiliar ground where they will be required to vote on future financings, etc. Make sure you only sell them what they can handle responsibly.

  • Don’t ask for money they can’t afford to lose.

If your uncle offers to give you $50,000, and he can afford to lose it, take it. But if that $50,000 is half of his 401(k), and will drastically affect his savings, leave it on the table. When asking for money, don’t take anything that can materially impact someone’s lifestyle if it’s lost.

  • Educate your friends and family on the investment cycle.

You’ll likely need to educate those close to you on how follow-on financing works so no one is surprised when their stake is diluted in later rounds. For exceptionally committed friends who want to invest in follow-on rounds, let them know that they’ll need to hold money in reserve to maintain their stake in the company as new money comes in. You don’t want an investor win feeling like a loss when the company gets sold and their return is reduced due to dilution.

Although it’s not for everyone, taking money from friends and family is an integral – and often necessary – step in the fundraising process, especially early on.

Having sat at both sides of the table, I’ve seen the toll it can take on personal relationships. While in my cases our relationships endured – largely because the failure wasn’t for lack of execution and empathy was the prevailing emotion – money can have a way of ruining friendships and straining family bonds, sometimes to extreme levels.

If you do decide to ask your dear Aunt Hilda to invest in your idea, do so wisely and be certain she knows the risks involved. You don’t want to jeopardize your most meaningful relationships because of shattered hopes and misunderstandings about money.

After all, if your venture flops, you’ll still want to be invited home for Thanksgiving and to your nephew’s next birthday party.

Or on your close friend’s next vacation.