Entrepreneur Office Hours - Issue #49

Stop trying to trick investors

Lots of fundraising advice (including my own) tends to focus on experienced investors. But a reader sent a question about friends and family fundraising that I couldn’t resist answering. For what it’s worth, I’m generally opposed to taking money from friends and family, but, if you’re going to do it, at least be sure to do it responsibly.

While I’m on the subject of responsible fundraising, in this issue you’ll also find an article about BS-ing investors. (And why you probably shouldn’t!)

If you’re not interested in fundraising, I’ve still got you covered with an article about product development. More specifically, it’s an article about why you shouldn’t focus on it.

But before you get to all of that, do me a favor and take a moment to click this big, orange button:

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-Aaron


The One Slide in Your Pitch Deck Investors Will Never Believe

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Are You Too Obsessed with Your Startup’s Product?

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Office Hours Q&A

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QUESTION:

Hi Aaron,

I need money to start building my product. It has to be designed and prototyped and manufactured before I can start selling, and all of that gets expensive. Not millions of dollars or anything, but I think it’s going to cost me around $50k, and I don’t have that much to spend.

I realize it’s not venture capital type of money, so I was thinking of asking “friends and family” for help. Is that what you would recommend? Any advice on the best ways to ask friends and family for money? I’ve never done that kind of thing before, and it makes me uncomfortable.

Thanks for sharing any thoughts you might have.

- Lenox

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For starters, this question is a great reminder that fundraising encompasses a lot more than what normally gets focused on by us so-called “entrepreneurship gurus” when we give advice about the best ways to raise capital for a startup.

Most of the fundraising advice I share is meant for venture capital style fundraising. Sometimes I’ll drift a bit toward angel fundraising (as I did a couple weeks ago). But friends and family fundraising is yet another different category. It also requires a completely different approach.

As the name suggests, “friends and family” fundraising means taking money from people in your personal networks. Usually (though not always) this happens during the earliest stages of a startup.

In the case of the question being asked here, based on what’s being shared, it seems like a reasonable scenario for “friends and family” money. That’s because the startup appears to be more of a nascent idea than an actual company, and ideas don’t usually get funded without at least some evidence they can work.

In contrast, when friends and family invest in startups, they’re usually investing in the founders more than the companies themselves. Sure, they might personally like the “ideas” they’re investing in, but, for the most part, they’re investing because they have a preexisting relationship with the founder, believe in that person’s abilities, and want to help that person succeed.

As for whether or not you (the original question asker) or you (the reader) should pursue friends and family funding, it’s a very personal decision. While I appreciate the value of having the closest people in your network supporting your startup ambitions (it’s great to be loved!), it can also be dangerously irresponsible.

Friends and family tend to be the least educated people in terms of understanding startups and their risks. At the same time, founders who need the small amounts of capital usually provided during friends and family funding rounds are often, themselves, inexperienced founders who don’t fully understand the risks they’re taking. This makes for a bad combination. It’s a proverbial “blind leading the blind” scenario, and those rarely end well.

My advice is to avoid taking “friends and family” money from actual friends and family. Instead, if you can manage it, I suggest figuring out how to make what I like to call “new friends.” Specifically, make friends with angel investors who are more seasoned and experienced in startups. Yes, this will take longer, however, if you can convince an experienced angel investor to commit a small amount of capital to your project, you’ll: (a) have validation you’re working on a worthwhile project; (b) be placing the risk on people better prepared for it; and (c) have experienced mentorship in addition to funding.

If experienced angels aren’t an option, have you considered alternate funding strategies? Have you looked into grants? Loans? Do you have any assets you can sell? Do you have any savings you can draw on? Partnerships? Convince someone to manufacture in exchange for equity? Would you be comfortable incurring credit card debt?

If none of those alternate funding sources are options, and taking money from friends and family is genuinely the only way to move forward, then the best way to ask for money is to be as transparent and honest about the risks as possible. Explain as much as you can about the project to the people you’re soliciting and be sure they understand that rejecting you won’t in any way damage your relationship with them. Also prepare them for the fact that giving you money could ultimately damage your relationship (I’ve seen it happen a lot).

Above all, be sure the people you’re soliciting understand that startups are not “get rich quick” schemes. Even in a world in which your idea is successful, it’s still going to take the better part of a decade, and that’s a long time to wait for a return on their investment. Plus, remember that a successful startup is one that returns 10x on the original capital. In your case, you mentioned looking for $50,000. If you’ve got five friends each giving you $10k, the best any of them can honestly hope for is $100k in return. Yes, 10x is an incredible ROI, but $100k isn’t exactly retirement money. So make sure they know your startup isn’t likely to make them rich even if it’s successful. This will help keep everyone’s expectations properly aligned which will, in turn, make the outcome -- whatever it is -- more positive.

Got startup questions of your own? Reply to this email with whatever you want to know, and I’ll do my best to answer!