Should I Invest in a Friend or Family Member's Startup?

When Jeff Bezos first decided to sell books online, he was fortunate enough to have financial support from his parents. As Bezos recalls:

"The first initial start-up capital for Amazon.com came primarily from my parents, and they invested a large fraction of their life savings in what became Amazon.com. And you know, that was a very bold and trusting thing for them to do because they didn't know. My dad's first question was, "What's the Internet?" Okay. So he wasn't making a bet on this company or this concept. He was making a bet on his son, as was my mother."

In fact this is a common story in startup funding both within Australia and around the world. Keen business founders with a big idea often turn to friends and family as their initial investors. Of course, this worked out well for Bezos' parents. Thanks in part to their support, their son is now one of the richest people in the world, and their initial investment is estimated to be worth tens of billions of dollars.

But of course we hear about the success stories. We do not hear so much about the parents who have lost their life savings on their child's failed business, or the friendships that have been shattered when promised riches did not arrive. And there are plenty of these.

So this is a delicate topic. If someone you care about invites you to invest in their startup, how do you handle it? You might want to show your support. But how do you do this while looking out for your own financial situation?

Consider the pitfalls

Although friends and family are a major source of startup finance in Australia, there are many pitfalls to watch out for, including:

financial loss - startups are risky by nature. They are unproven, they have no track record, and they are often trying to make their way into a market with established competitors.
damaged relationships - there is a serious risk that a dispute over money could cause irreparable harm to your relationship. Many families and friendships have been torn apart by disputes over money. Tragically, many of these disputes could have been avoided, if the parties took the right steps when starting out.
unrealistic expectations - seasoned investors and business owners might aware of the real business challenges that they are facing. But excited young entrepreneurs might not have the same perspective. In fact it is very common for startup founders to be overly optimistic about their business's prospects. This can lead them to overvalue the business which can lead to significant problems for their investors.

This is an obvious point but it helps to take a moment and remind ourselves of this. It is absolutely ok for you to say "No".

Remember - you do not have to provide any money. And if you still want to help, there may be other ways you can do so.

Even if the founder is someone you care deeply about, if, after considering their proposal, you are not comfortable investing, then the best thing you can do is to politely turn them down.

There are many other ways for you to offer your support, such as promoting them on social media, offering some of your services, pre-ordering some of their products, or putting them in contact with people who you think can help them. You most likely have your own financial responsibilities, which the founder is not aware of. But perhaps you know someone else who is looking for a new project to get involved with. See "Other forms of support", below, for further discussion about other ways you might show your support.

If you allow yourself to be pressured to invest your money when you are not comfortable doing so, then this can lead to resentment or friction in the relationship which can be difficult to overcome. Furthermore there are the financial consequences if the business fails.

Therefore, it is important for all parties to take some time to assess the situation before finalising any finance terms. If necessary, the parties can engage professionals such as lawyers, accountants, financial advisors or business consultants to assist at this stage.

Preliminary steps

If the parties want to discuss the proposal, but are not ready to finalise the terms of the funding, then there are a number of preliminary steps they can take.

Firstly, the founder might ask prospective investors to sign a Confidentiality Agreement (also known as a Non-Disclosure Agreement). This is very normal in relation to startups, and it allows the founder to protect their business ideas, intellectual property and other confidential information, while discussing their business with a variety of potential investors. This is discussed further in our guide Do I Need to Sign a Confidentiality Agreement?

Secondly, if the parties come to some kind of "in principle" agreement, with further details to be finalised at a later date, then they may choose to sign a Memorandum of Understanding. This document is generally non-binding, and sets out some basic terms that the parties have discussed. It is intended as a starting point for the parties, as it enables them to set out the preliminary understanding between one another, and can help them to work towards a more formal agreement. For further information about this matter, see our guide What is a Memorandum of Understanding and is it Legally Binding?

In some cases, if the business is just starting out, and if the investor is going to own part of the business, then an Agreement Between Co-Founders (Non-Binding) might be appropriate. This is another document which is generally non-binding and it is designed as a quick and easy solution for business founders. It helps them to address a number of important preliminary issues and to avoid disputes down the track.

Do your due diligence on the business

Broadly speaking, you are going to need to make a decision about the potential risks and rewards of this investment, so that you can determine whether or not to hand your money over.

Of course, you can choose not to assess the investment, and to just hand your money over. But if you do so, you leave a lot to fate, and you really should consider the money a "gift" rather than an "investment". Some people (such as wealthy parents) might choose to do this if they are happy to lose the money, and just want to show a bit of support. But this does put you at much greater risk of losing your money, and it also does not help the founder to develop responsible business practices.

Doing your due diligence means reviewing the business proposal, the terms of the investment, and the founder(s), to determine the worth of the investment. Depending on the complexity of the proposal, it might be necessary to engage professionals such as lawyers, accountants, financial advisors or business consultants, to help you make this decision. For smaller investments or more simple proposals you might make the decision on your own.

In relation to the business, there are many things to consider, including:

what will the business do?
what problem does the business solve?
what are the strengths and weaknesses of the business?
what is unique about the business?
what market will it operate in?
how are the founder(s) making their assumptions about the business opportunity? What have they done to actually test the market? For example, have they conducted any market research or released any prototype products?
what opportunities are there in that market?
how big is the market opportunity?
how big can the business grow?
what competition is there in that market?
what competitive advantage does the business have?
what advantage do competitors have over the business?
who are the founder(s)?
are the founders reliable and trustworthy?
what relevant skills and experience do the founder(s) have?
what other personnel are required in future?
how will the business generate income?
what is the marketing strategy?
what is the advertising strategy?
what is the cost of customer acquisition?
what threats does the business face? Eg could a simple change in government policy kill the business?
what legal, regulatory or licensing requirements does the business need to comply with?
are there any liability risks (for example, product liability or negligence claims)?
what insurance does the business need?

These are only some of the questions that you might need to ask about the business. So take your time, and if in doubt, seek advice from professionals such as lawyers, accountants, financial advisors or business consultants.

On what terms are you providing the funding?

It is worth remembering that the terms of funding are entirely negotiable. The founder might have presented a proposal to you, but it is normal, and reasonable, for you negotiate some changes to those terms if you require them.

In relation to the terms of the funding, there are many things to consider, including:

how much money are you providing?
what do you get in return for it?
what is the founder going to use the money for?
is it a loan, or are you buying a portion of the business?
what is the legal structure of the business?
what rights and responsibilities do you have?

Some of the most common ways for friends and family to provide startup funding in Australia are by providing a loan, or by buying shares in the business.

Loan

This is one of the most common ways that friends and family members choose to fund startups in Australia. If providing a loan, then there are a number of things to consider, such as:

when do you get repaid?
what is the interest rate?
is the loan secured? If so, what is the security, and are there any other loans secured against the same asset?
what happens if you are not repaid on the due date(s)? Are there penalties?
what if the business fails? How will you be repaid? Are there other creditors who will get paid before you?
what entity is the borrower (eg is it a company, or a person)?
if the borrower is a company, is it necessary to get guarantees from the directors?
even if the borrower is not a company, is it appropriate to have guarantors sign the loan?

We have a Loan Agreement available for this purpose. We also discuss loans in more detail in our guide Should I Lend Money to Friends or Family?

Buying shares in the business

Another common way that friends and family members choose to fund startups in Australia is by buying shares in the company. If the investor does this, then they become an owner of the company, which comes with various rights and obligations. The Australian Securities and Investments Commission provides further information about the rights and obligations of shareholders.

When the investor purchases shares in the company, they should be issued with a Share Certificate.

The rights and obligations of the shareholders in the company can also be set out in a Shareholders Agreement. This is a contract which is signed between the shareholders. Alternatively, if there is a pre-existing Shareholders Agreement, and the investor wants to become a party to it, then they can sign a Deed of Accession.

In any case, if the investor is planning to buy shares in the business then they should conduct their due diligence on the company and should carefully review the Shareholders Agreement to see what their rights and responsibilities will be.

Other forms of support

Aside from providing a loan or investing in the business, there may be other ways for you to provide support. For example:

Joint Venture - perhaps you own your own business as well, and want to team up with your friend/family member to work together on a project. A Joint Venture Agreement would allow you to do this, while keeping both or your businesses separate from each other.
Providing services - perhaps you want to provide some services to your friend/family member. Even if you are not charging any money for this, it is a good idea to document the relationship so you make it clear what you will (and will not) be able to provide, what you expect from the other party, and importantly, what liability you accept in relation to the services. A Service Agreement would allow you to do this.
Providing equipment - perhaps you want to lend some equipment to your friend/family member to get them started. Again, you should document this relationship, even if you are not charging any money for this to make sure important issues such as liability are addressed. An Equipment Rental Agreement would allow you to do this.
Pre-purchasing goods - perhaps you want to pre-purchase some goods from your friend/family member, providing them cash now for goods they don't need to deliver until later on. A Contract for Sale of Goods would allow you to do this and would set out all of the details of the cash and goods to be provided, and timing of delivery.

In conclusion

It is very common for Australian startup founders to seek funding from friends and family members. When it works out, it can be a great result for all involved. The founder gets the support they need to get their business off the ground, and the investor gets to share in the financial success of the business. But unfortunately, it does not always work out.

This means it is essential for the parties to take some time getting their ducks in a row. The investor needs to conduct their due diligence on the business and the investment proposal. Both parties need to consider the terms of the funding, to make sure they are happy with how it will proceed.

To avoid any confusion or disagreement down the track, it is also important that the terms of the agreement be set out in writing. There are a number of different documents which may be used along the way, many of which are available on our website.

As with any legal matters, if the parties have any concerns, then they should seek legal advice.