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Stuart Garfield
Friday, October 31, 2008
Inside Finance Strategies
Friends and family financing remains at the heart of most startups
By Jay Rizoli, Special to Mass High Tech
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When that flash of ingenuity strikes and you have a can’t-miss idea for a product, company or website, it’s likely that a friend, colleague or family member will be the first to hear about it. And if yours is like the majority of startups, those are also the people you’re going to ask to help pay for it.
Friends-and-family investment accounts for more than 70 percent of all venture dollars for startups, according to a Babson College-London Business School study.
Greg Boesel, CEO of Swaptree Inc., who with co-founder Mark Hexamer has started two companies with friends-and-family cash, says, “I think that everybody does it. More importantly, I think that everyone should do it. If you are starting a company and you can’t convince any of your friends and family that it is a business that has a chance of succeeding and that you are capable of doing everything necessary to make it a success, then you really shouldn’t pursue it. If you can’t convince your friends and family that your business is a good idea, you will never be able to convince an outside investor.”
Ideally, that first round is intended to get the ball rolling and give the company some traction en route to those outside investors. In the case of Swaptree — a site for users to trade books, video games, CDs and DVDs — that meant getting the website up and running and ready to initiate trades so that there was something to show to other investors. Swaptree then raised a much larger, angel round, and many of the original friends and family re-upped. But success is more than just a matter of taking checks from people you know and then building a company. It’s a risky endeavor, and what you don’t know can hurt you.
“You should make sure that if you do borrow, you document it properly,” said Asheesh Advani, president and CEO of Virgin Money USA, which he founded in 2001 as CircleLending to help entrepreneurs raise capital in the absence of credit. His company helps customers manage friends-and-family money, choosing interest rates and loan terms to fit their particular situation, save on taxes and build a credit history.
“We help create a paper trail,” said Advani, a former entrepreneur-in-residence at Monitor Group, executive at The World Bank and author of Investors in Your Backyard: How to Raise Business Capital from the People You Know. “That way the borrower wins, the lender wins and the future investor has more transparency about how the company was financed.” And Advani will tell you he’s not just the president, he’s also a client: CircleLending was financed by friends and family.
Documenting investments also helps draw other investors by enabling the founders to point to investors who have faith in the company, Boesel said.
Certainly, some efforts are a better fit for friends-and-family financing than others, and some tech sectors can be among the least suitable. Boesel’s first company, Sidebar Software, made a legal research and citation software called CiteIt!, which can be harder for the average person to relate to than swapping books and CDs online, he said. While it’s a tough fit for arcane concepts, it’s tougher for longer-term efforts.
“It doesn’t work well for big companies with big concepts that won’t have revenue for 10 years, like if you’re a biotech company,” Advani said. “If you’re looking at revenue in two or three years, this is perfectly fine.”
And what if it doesn’t work at all? Boesel says that while you want to believe an idea will be big, it’s important for them to know that it may not be.
“You have to tell people when they’re writing the check, ‘You’ll probably never see this money again,’” Boesel said. “But it’s not as tough to make the case because they know it could be big. Lots of things can go wrong, and I think people appreciate that because it reminds them that yes, this is a startup and it takes time and patience.”
And that patience is something you’re likely to find much more of in friends and family than in professional sources.
“Working with friends and family has afforded us the freedom to grow our company in the way we felt was the most healthy,” said Mark Daniels, co-founder of Cambridge-based Digital Field Theory LLC, developer of basketball simulation game BuzzerBeater. “We were able to put aside all thoughts of hurdle rates and the arbitrary financial milestones that VC firms can demand and focus instead on our core principles — to develop the best product, to make the customers happy, and to have fun in the process. As a result, I think our company will be stronger in the end.”
Still, those closest to you will be continually curious and, well, close to you — what some call “the Thanksgiving Dinner problem.” But Boesel says that can be a good thing.
“You know the first thing that people are going to ask is, ‘How’s Swaptree going?’ ” Boesel said. “So that’s one major pitfall. But if you’re going 150 percent, they’re never going to fault you for that.
“Once you reach the next round and have higher valuation that takes a little bit of the pressure off. It’s always a topic of discussion whenever you call, and we probably worry about it more than they do. But we try to keep in touch with regular communications. People just want to know that you’re working hard, and we always tell them, ‘If there are any questions give us a call. We owe that to you.’”
Jay Rizoli is a freelance writer in Franklin.
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