The Wall Street Journal
By: Dyan Machan
August 6, 2010
Bank lending to small businesses is still in the dumpster, and venture capital investment remains way down. But even if times were flush, some entrepreneurs would rather get funding elsewhere. Business owners like Erica Duignan Minnihan and Susan Reiner wouldn't take out a bank loan if President Obama delivered it on a silver platter. They've turned to a capital source often better suited to slow-growing times: friends and family.
According to a University of Michigan study of entrepreneurs, the lion's share of initial start-up capital comes from individual savings, friends and family. Though numbers don't track it, under-the-radar financing may be gaining in this economic climate, according to William Dunkelberg, chief economist for the National Federation of Independent Business. Even among banks that want to fund start-ups, he says, "no one is exactly knocking down their door." If Mom, Dad and the neighbors are a more popular option, it's not because they're a soft touch; it's because they're less likely to demand terms that constrain the way the business develops.
Duignan Minnihan, 34, is an MBA-wielding mother of three; having worked in investment banking and for an angel investor group, she certainly has contacts for fund-raising. But when she needed $50,000-plus to launch her online business--Healthy Mama Enterprises, which sells the Mamatini, a beverage for nursing mothers--she looked no further than her parents. Why not outsiders? "Too expensive," she says. The typical angel investor, she says, wants a tenfold return on capital in five years--quite a challenge, "unless you can spin gold out of straw." Her parents, of course, weren't so demanding. Duignan Minnihan works from home and outsources tasks to keep overhead low. Her strategy is to get established before she considers courting bigger investors: "I don't want to take $1 million and get in trouble."
Ms. Reiner, with partner Wendy Drapanas, started Rock of Ages Press in 2008 to sell products with a spiritual bent to boutiques. A friend who had retired from the mutual fund industry offered start-up funding of several hundred thousand dollars. Ms. Reiner and Ms. Drapanas granted him 51 percent of the company, but the founders retain the right to buy back some of those shares when they repay his investment; it's rare to obtain such favorable terms from an angel investor.
Of course, just because investors are friendly (or genetically linked) doesn't mean the relationship should be casual. It's crucial to formalize financial arrangements. Duignan Minnihan, for example, signed a convertible note that gives her parents the right to claim equity in her company. She also drew up a formal business plan, just as she would have for the folks at the bank. Gauging investors' risk tolerance is also important. When the founders of Bonobos.com, a men's clothing retailer, launched their company, family members sought to pitch in, recalls CEO Andy Dunn. But the team ultimately raised money only from the few who could afford to lose it; otherwise, should business go awry, "that can invite some serious dysfunction into your life," notes Mr. Dunn.
Today Bonobos.com has $5 million in annual sales--and about 30 friends-and-family investors, who also act as word-of-mouth marketers. The only (minor) downside? "When we hang out, I get a million Bonobos questions," Mr. Dunn admits. Hence the final lesson on fund-raising from pals: Set appropriate conversational boundaries.