Why you should never tap friends and family for startup funds

You’ve probably heard this line: “If you can’t raise money from angels you can raise from your friends or family.” In fact most young entrepreneurs raise money from friends and family, here is a quick breakdown of funding sources for startups from AngelBlog.

I am writing this article to tell you from personal experience: raising money from friends and family is a VERY BAD IDEA. It may kill your startup and your relationships with friends and family.

Think back to the time when you pitched your startup to family and friends. Did you sound a little like this guy in the video below?

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Your family and friends probably gave you some money based on a pitch like this one.

Seven years ago when the recession hit and I filed bankruptcy for my construction company and wanted to build an online business, there was only one ‘but’: I knew nothing about online businesses.

I started to read blogs on entrepreneurship and read countless success stories about young kids raising money from friends and family and bootstrapping their business until they eventually made it big. It seemed like an easy way to get started: borrow money from friends and family, build your business and then decide how to expand.

I decided that if I ever need money to build a business I’ll ask my friends and family.

I started my first startup in 2007: a company named Lapox, which was going to blow Yahoo.com right out of the water. I know, it sounds ridiculous! If I had known then what I know now.

I tried to raise $50K from friends, family and investors right away. I raised a total of $0. Perhaps my friends were trying to tell me something about my idea. After a few months, I decided to forgo my idea for a startup since I had no capital.

I started another startup at the end of 2008 and named it Nigmo. Nigmo was an electronics e-commerce store that sold a lot of different types of smartphone accessories. We did not need to raise money initially and gained some good traction right away. Within the first year of operation, I sold $100,000 worth of accessories through Nigmo.

It took me a whole year to realize that the phone accessories market was an extremely crowded space, and it was very hard to build a profitable business since competition was insanely fierce. I shut my second startup down in a matter of days.

My third business was in affiliate marketing space, and I was happy that I did not need any outside investment to get it off the ground. It grew rapidly and showed legs right away.

I had a new idea and started my fourth business that was a Facebook + Amazon e-Commerce marketplace based on recommendations from your connections. Your friends who recommend products would get a kickback if you bought something they recommended. Friends could only recommend products they bought. I named it Idooble.

Idooble needed investment, and I decided to follow the advice I read about back in 2007. I borrowed a total of $600K from my close friends in Toronto and Moscow to start the company, and I put $300K of my money into the company.

In the course of the next 18 months, we burned through all of $900K as we scaled the company to nearly 30 employees and 40,000 customers. Before we realized that we did not know how to scale business properly any further. We needed a lot more capital to keep scaling the business. We had to shut it down. There was a slew of other problems with this business – of which I outlined a few in another article I wrote on TNW.

We closed the business down in a day: 40,000 customers gone in just one day, and I was left owing $600K to very close friends. I could not bankrupt the company and not pay back my friends, it would essentially mean I’d be stealing money from them. I had to pay it back.

I know I’m not alone. I’m sure many of you probably faced the same situation when you borrowed money from friends and family.

90 percent of businesses fail in their first year of business.

If you took money from friends or family remember one thing: you have to pay it back. You cannot file bankruptcy. These are your friends and family, and you do not want to steal money from them.

It’s a tough situation to be in.

I recently had a meeting with a young and eager entrepreneur working on a competitor to Viber. He was insanely confident he could grow to 600M users in a year and crush Viber.

He was building his prototype and met with me because he wanted to raise some capital. Too early? I’d say so.

I remember when I was just like this guy: wild, eager and blind, eyes on the prize, always running. I think every entrepreneur is eager and blind at the beginning of their career.

I’m sure many of you have ideas, and maybe you are already working on something that will ‘change the world’. I have one word of humble advice for you: If you are looking to raise funding and you don’t have a proven revenue stream from your product: STOP!

Here are three lessons learned which I want to pass on to you:

Never raise or borrow money before you have a revenue stream. Prove the business model first and have a solid revenue stream before you borrow or raise. Remember there is a 99 percent chance your business will fail which means there is a 99 percent chance you will be in debt to your friends or family if you borrow or raise money. Even successful entrepreneurs don’t have a high success rate. Make sure you have a solid revenue stream before you start raising or borrowing money.
Never borrow money from family and friends. All I can say is that I guarantee you will ruin your relationships with family and friends by borrowing money and not being able to return it.
Never quit your day job before you have an income stream that can sustain you. It sounds very romantic to quit your day job to follow your dream and build something you want. People quit their day job with a notion that “money will come” if their idea is great. It’s a fairy tale. The reality is quite the opposite. Don’t quit your day job until the revenue from your startup can sustain you.

Instead try to follow this as close as possible:

1-6 months: Learn the Skills You Lack

You have an idea for a startup, what do you do next?

In my case, it was Facebook + Amazon e-commerce website. What did I do? I jumped at implementation right away.

What happened in the end? I did not have enough expertise to keep scaling the business at the point when we had 40,000 users and had to shut it down.

What should I have done? My step #1 should have been to identify skills I lack and start learning.

Same for any young entrepreneur, you should identify which skills you lack to build your startup and take courses to become proficient at these skills.

Coding? Design? Marketing? What do you lack and should learn? If you have a partner who is good at coding and you’re the business guy, perhaps you should learn how to grow your business or do PR on your own. If you’re a developer, maybe you should learn design?

You get the idea. Learn the skills that you lack and will need to build your startup as you bootstrap. You can learn these skills as you start implementing your product but focus on learning. Here are just a few great resources that will help you learn more efficiently.

6-12 months: Make some revenue

Your next focus is to get to revenue as fast as possible. You can do so by selling your product idea and asking people to prepay you or building an MVP (minimum viable product) and making your first revenue.

The goal is to start making some revenue online with your product. You are still working your day job to make ends meet so this is not as easy.

12-24 months: Grow revenue to quit your job

The next step is to grow your revenue so you can leave your job. Focus on scaling your income. It will be very hard to grow your income from $3K/mo to $10K/mo. You may spend years trying to get to the point when you will make $30K a month.

24-48 months: Build a killer team

At this stage, you have a solid revenue stream, and you can start to scale your company. You need more people in order to scale and you need more revenue to hire more people. It’s a bit of a chicken and egg problem.

Do not hire too fast, hire with great care. Use the revenue you have to hire people you actually need at the moment. These people will help you scale revenue so you can hire more people. Your first team members should be people who you work well with and who are experts in things you know very little about. Always focus on your net income when deciding how many people you can hire.

48+ months: You can now borrow or raise money

At this point, you should have a dream team of 5-8 people, $300-500K in your bank account and a solid revenue stream. Now you can think about taking on investment only if you need it to scale faster. You can always use the cash you have in the bank to invest into the company.

Sit down with your team and brainstorm: Do you really need outside investment to scale? Why do you need it? How else can you fund your efforts?

And that’s a wrap!

I know that what I outlined above is an ideal scenario and we do not live in an ideal world. All I ask is that you stick as close to this as you can if you are a young entrepreneur. Resist the urge to raise or borrow quick money from friends and family. Build a business first.

Trust me, I’ve been there.

I burned through $1.5M in 3 months, fired 100 people, closed the company and owed 600k in personal loans. I managed to bounce back and build a successful business after this.

All I ask is that you take the time to build something of value which has a promising revenue stream before you start asking others to give you money.

Questions or comments – I’d love to chat, just leave your note below.

Image credit: Shutterstock