Investing in the family entrepreneur
At a time when it can seem as if every household contains a budding entrepreneur, it is only natural that the search for funding is hitting closer to home. Here are some rules of the road for entering into a startup with family members.
Several years ago, a young television and video producer was looking for funds to start a boutique production company focused on political activism. The amount of money wasn’t gigantic, but the producer, lacking assets for collateral, didn’t want to jeopardize her financial future by taking out a large loan—and her parents were even less crazy about the idea. So they offered to give her the money instead.
The producer refused. She didn’t want a handout. So after speaking with a financial advisor, she and her parents chose to use an intra-family loan, which allows family members to lend funds to one another at substantially below-market interest rates and avoid federal gift-tax provisions. The loan, for $50,000, was repaid within a few years and the production company got off the ground. The business is now a successful concern with a popular cable show to its credit and a healthy roster of corporate and nonprofit clients.
During the past few years, nontraditional forms of financing have become increasingly popular in the startup world. From crowdfunding to the proliferation of incubator programs and seed capital funds, early-stage ventures can increasingly tap a variety of funding sources. Yet for every Kickstarter viral sensation or Silicon Valley incubator darling, thousands of young entrepreneurs, whether from bad luck or the lack of an established track record, struggle to find funding to bring their entrepreneurial vision to life. For them, leveraging the resources of a parent can be a leg up, providing a way forward when no other option exists.
Many people would like to pass on the values they see as necessary for creating wealth, like patience and perseverance and entrepreneurial zeal.
Indeed, according to a Bank of America Private Bank (formerly known as U.S. Trust) report, 35% of the Millennial/ Gen X generation and 54% of Baby Boomers have relied on personal/family savings with the rest coming from more common funding activities.1 Also, of the 37% of individuals who don’t fully own their business, 16% share it with a family member or spouse.2
As for the parents, the motivation behind such investments is invariably complex. Parents want their children to succeed and may even feel a certain obligation to help. According to the 2018 Insights on Wealth and Worth Survey® from Bank of America Private Bank, many parents today are investing in the success of their children. Twenty-seven percent have already loaned, or are willing to loan money for the startup of a business, and 20% say they are willing to provide upfront capital to fund a business startup. However, parents may have another reason for getting involved in an adult child’s business venture: They may see it as an investment that can actually make some money.
A number of young entrepreneurs choose to enter into the burgeoning tech industry. One individual, for example, became the founder of a profitable Web publishing company. After spending a couple of years refining the concept, the company is now generating close to $700,000 a month in revenues, and already issuing distributions to its dozen early seed investors—including the founder’s father.
Could he have started the company without his dad? Probably. But did it help to have that friendly source of funding to get the ball rolling? Absolutely. Of course, at this point the dad is probably just as happy with his investment.
Six Rules of Family-Backed Startups
Intra-family angel investments or loans can be a good idea, as long as both parties treat it as a business deal. Here are some suggested best practices from Merrill advisors.
- If it’s not going to work, don’t do it. A family member’s business is still a business, and businesses must be carefully vetted before financial support is extended. If the two sides realize a venture isn’t going to work out, abandoning it early on might be the smartest decision of all.
- Do it right. Both parties should think of themselves as business partners, not simply as the check writer and the beneficiary. If you think something needs to be changed, speak up. A parent should be just as involved as he or she would be if complete strangers were running the business.
- Bring in an outsider. Sometimes the best way to start off a potential family business venture is for the parents to bring in an outside consultant who can provide expertise to help them vet the proposal, and also relieve them of the guilt if it becomes apparent that the deal just doesn’t work.
- Structure, structure, structure. A clearly articulated business plan along with a legally binding contract that defines roles, responsibilities, incentives and protections can mitigate some of the biggest risks that go with a family-staked venture. It can be tempting for parents and children to take such things for granted, but they shouldn’t.
- Take the approach of a bank. If the deal involves debt, consider using a promissory note so that there are clear expectations that repayment is expected. Even if you decide to deviate from them, consider what competitive loan terms might look like. Think about what the business is truly capable of paying back, as well as options like convertible debt that may allow you to keep more money in the business.
- Have a ceiling. Data suggest that the vast majority of new businesses fail to produce their projected return on investment and many of the businesses that succeed end up losing money for a considerable period of time. Everyone needs to set a realistic limit in advance and to know when to say when.4
Still, for many parents, the idea of funding a child’s business may trigger mixed feelings, raising the question of whether they are violating some unspoken rule against raising healthy, independent children. According to a similar Bank of America Private Bank report, about 10% of HNW family wealth overall comes from the wealth handed down from one generation to the next.3 “The dangers of inherited wealth are real,” says David Waitrovich, a San Francisco–based Merrill Private Wealth Management managing director and private wealth advisor who works with many entrepreneurial families. Many people would like to pass on the values they see as necessary for creating wealth, like patience and perseverance and entrepreneurial zeal. Unfortunately, it’s often easier said than done. The irony, of course, is that a startup can be the formative experience that helps instill those values. After all, what better way to acquire entrepreneurial fire in the belly and solid financial stewardship than in a business, with real money at stake and real consequences for failure? The process needs to be managed carefully from the outset in order to see benefits as well as specific risks for parents investing in their children’s ventures.
Some parents dread the thought of coddling their children and end up imposing more stringent terms than they would with another business partner. For others, there’s an aversion to establishing rules of any kind—they don’t want to attach strings and make the child feel like a puppet. This can lead to a lack of direction and accountability—both of which are critical to any entrepreneurial venture.
So what is the happy medium between too much and too little support?
As an example, a couple decided to invest in their son’s business ventures. The son had several valid startup ideas, but none were fully formed. The family, however, wanted to show its support for him and essentially gave him a blank check. Five million dollars and several bankruptcies later, the dynamic that truly makes a family business challenging—the potential for emotional damage—had kicked in. The son’s businesses failed, which in turn led to the collapse of his marriage and his parents paying his alimony.
So much of it was probably preventable. You can’t guarantee a business will be a success, but you can structure the investment in a way that maximizes its chances, while greatly reducing the potential for emotional fallout.
So what is the happy medium between too much and too little support? A systematic approach that aims for accountability and transparency. Some of the worst scenarios, Waitrovich says, play out when people try so hard to avoid emotional messiness that they avoid any sort of planning or discussion at all.
“Money is emotionally charged, especially in a family situation,” says Valerie Galinskaya, managing director in the Merrill Center for Family WealthTM. “With a family business, everyone’s keeping score.”
As Galinskaya notes, starting a business is difficult enough, and that’s without the backers reminding the founder of the time he or she crashed the car in high school, or the CEO claiming the backers have “never understood” what he or she is trying to do. “Which is why you want to try to stick to the facts at hand as much as possible,” she says.
One solution for getting things off on the right foot is for the parents to bring in an outside consultant with expertise native to the startup, to help them evaluate the deal. If the business plan is not well thought out or the market is already saturated, “this will naturally come out during the expert’s due diligence,” says Galinskaya, “which relieves Mom and Dad of the guilt and emotionality of saying no without an objective evaluation.” If the company is launched, a skilled business coach can be helpful to support the success of the entrepreneur.
To strike the right balance, some families gather to discuss their philosophy on using family wealth to fund entrepreneurship, and develop guidelines so that everyone is clear about the process they will use to consider ventures. One family Galinskaya works with went so far as to establish its own intra-family entrepreneurial fund. In addition to requiring that each new proposal be vetted by an outside expert, the fund caps any intra-family loan or investment to $250,000 in the first year of a business and to $750,000 over the next five, and limits the entire fund to no more than 10 percent of the family’s total financial capital. Having established those parameters, reports Galinskaya, the fund has already invested in the startup of one family member in their late twenties, and is “actively looking at purchasing another business for a second.”
The Seed Fund Inside Your Monthly Statement
One important consideration in many intra-family business arrangements is striking the right balance between providing some financial stability to a young enterprise and not compromising the parents’ own liquidity position. For some families, the solution could be tapping the securities-backed lending capabilities of the parents’ own investment account.
Parents may want to consider a Loan Management Account® (LMA®)*5, a flexible line of credit payable on demand that is offered by Bank of America, N.A., that allows assets in the parents’ stock and bond portfolio to be used as collateral for a low-interest loan that the parents can put to use in a variety of ways. In one option, the parents can take out the loan in their name and use it to free up cash to fund an equity stake in the business. They can also leverage the funds for debt, simply re-loaning the cash to the business at whatever terms they set. Alternatively, the loan can be taken out in the name of the business, with the business becoming responsible for making all interest and principal payments directly to Bank of America, while still benefitting from the same favorable terms that the parents enjoy from having the loan backed by their assets.
These loans provide a maximum amount of flexibility for both the givers and the receivers. You can loan the funds directly to your entrepreneurial children or grandchildren. You can gift the funds to them. Or you can use your assets as collateral for a loan they take out in their own name.
Before utilizing a Loan Management Account, all the benefits and risks should be considered.
RULES OF THE ROAD
Once the family has decided to support an entrepreneur’s business venture, it’s important not to let filial loyalties replace standard business practices. While family members may find it awkward to hire lawyers to detail investor safeguards and performance incentives, such feelings need to be set aside.
One of the main decisions family bankers and entrepreneurs will face is how to structure financing. The principal choice comes down to debt versus equity, but as with any startup, there can be many permutations.
If the choice is equity, the degree to which stakes can be diluted will have to be decided (should additional financing come in) as well as if and when distributions might be issued if the business achieves profitability.
Family members may recognize subtle personal traits the market doesn’t, such as a nose for innovation or a tenacious streak.
If the family opts for debt, repayment terms will need to be settled. As with equity, the parties have the option of taking money out of the business (to pay down the debt) or leaving it in until a future funding round. They may also decide to make the debt “convertible,” so that if more funding materializes, the parent can convert the debt to an equity share, perhaps at a preferential rate that discounts the new valuation of the company to bump up the parent’s share in recognition of the early support.
In the end, of course, whichever structure is agreed on, the decision to move forward, as in any new business, requires a leap of faith. Approximately 25% of startups fail within the first year, and 50% fail within the first four years, according to figures from Statistic Brain Research Institute.6 Family members may recognize subtle personal traits the market doesn’t, such as a nose for innovation or a tenacious streak. Handled the right way, supporting these qualities at a nascent phase can yield returns, even if the intangible benefits end up outweighing the material rewards.
“Entrepreneurs play an extraordinary role in American capitalism,” says Waitrovich. “They contribute to the economy many times over through business and often philanthropy. They’re the builders. I think it’s great if families want to nurture their own entrepreneurs, and we can help them do it.”
4 “The Top 20 Reasons Startups Fail,” CB Insights 2018 Update. Based on the analysis of 101 startup postmortems, startups fail due to no market need (42%), a lack of sufficient capital (29%), the assembly of the wrong team for the project (23%) and superior competition (19%).
5 The Loan Management Account® (LMA® account) is a demand line of credit provided by Bank of America, N.A., Member FDIC. Equal Opportunity Lender. The LMA account requires a brokerage account at Merrill Lynch, Pierce, Fenner & Smith Incorporated and sufficient eligible collateral to support a minimum credit facility size of $100,000. All securities are subject to credit approval, and Bank of America, N.A., may change its collateral maintenance requirements at any time. Securities-based financing involves special risks and is not for everyone. When considering a securities-based loan, consideration should be given to individual requirements, portfolio composition and risk tolerance, as well as capital gains, portfolio performance expectations and investment time horizon. The securities or other assets in any collateral account may be sold to meet a collateral call without notice to the client. The client is not entitled to an extension of time on the collateral call, and the client is not entitled to choose which securities or other assets will be sold. The client can lose more funds than deposited in such collateral account. The LMA account is uncommitted, and Bank of America, N.A., may demand full repayment at any time. A complete description of the loan terms can be found within the LMA agreement. Clients should consult their own independent tax and legal advisors. Some restrictions may apply to purpose loans, and not all managed accounts are eligible as collateral. All applications for LMA accounts are subject to approval by Bank of America, N.A. For fixed-rate and term advances, principal payments made prior to the due date will be subject to a breakage fee.
*Loans may provide a maximum amount of flexibility for both the givers and receivers. Funds can be loaned or gifted directly to entrepreneurial children or grandchildren. Assets may also be used as collateral for a loan they take out in their own name.
Case studies do not necessarily represent the experiences of other clients, nor do they indicate future performance. Investment results may vary. The strategies discussed are not appropriate for every investor and should be considered given a person’s investment objectives, financial situation and particular needs. Clients should review with their Merrill Private Wealth Advisor the terms, conditions and risks involved with specific products and services.
Past performance is no guarantee of future results.
The article is provided for informational and educational purposes only. The opinions, assumptions, estimates and views expressed are those of the author, and are, as of the date of this publication, subject to change, and do not necessarily reflect the opinions and views of Bank of America Corporation or any of its affiliates. The information does not constitute advice for making any investment decision or its tax consequences and is not intended as a recommendation, offer or solicitation for the purchase or sale of any investment product or service. Before acting on the information provided, you should consider whether it is in your best interest based on your circumstances and, if necessary, seek professional advice.