As the economy slows and credit gets tighter, more entrepreneurs looking to fund start-ups are turning to individuals they know personally rather than big financial institutions.
A significant 35% of small-business borrowers sought financing from friends and family, according to a recent survey by
Discover Financial Services.
But if you're the rich sister, or the uncle with a tidy nest egg, how do you know when to get out your checkbook -- and when to say a polite but firm no?
If you see the following red flags, run the other way -- even from family:
Turning a great idea into profits isn't easy.
An investment pitch should include a thorough business plan that addresses the project's financials, marketing research, a description of operation procedures and a payback plan for investors.
"Pretend you're a bank, and avoid anyone who hasn't done their homework," advises Doug Ware, a volunteer with the Orlando chapter of
SCORE, a nonprofit organization that educates entrepreneurs.
A Lousy Track Record
You want to bet on a winner, not a newbie who's looking to test his or her abilities on your dime.
With most traditional investments, past performance is no guarantee of future results. But with entrepreneurs, past ventures can hint at a new effort's chance for success.
Of course all entrepreneurs miss the mark at some point, so a failure or two shouldn't necessarily prompt you to walk away.
"Ask them what they learned from the experience, and how they will apply those lessons now," Ware says.
Urgent appeals such as "We're closing the deal and need a check by Friday" should give you pause.
Typically, the entrepreneur is rushing you for a reason: Maybe he doesn't want to give you time for due diligence because he has something to hide. Or maybe he's just impatient.
Either way, pressure to invest seldom reflects a real time crunch, explains Ken Gaebler, president of Chicago-based
A well thought-out business plan shouldn't rely on last-second infusions of cash.
Make sure the fundraising plan matches the goal.
If your cousin asks you for $10,000 to launch a software company, he's probably making the mistake that too many business owners make -- not realizing how much money they'll need to get going, and to reach profitability.
Not Enough Return
New businesses in the early stages are risky propositions.
As an investor, you're entitled to a potentially big upside, so beware if the entrepreneur wants to pay your principal back with a little interest.
"Let's say the idea is worth $100,000, and I put in $50,000," Gaebler says. "That puts the value of the company at $150,000, and I should get a one-third stake in the company."
No Skin in the Game
Be skeptical of entrepreneurs who want you to take a risk without risking themselves.
"You don't want someone who can lose your money without losing sleep," Gaebler says.
Ask them whether they have money invested in the business, or have taken loans secured by their house.
Even if none of these red flags are present, proceed cautiously into any investment. Always get satisfactory answers to all of your questions.
"Part of your homework is making sure they've done their homework," Gaebler reminds.
Mike Woelflein is a business and personal finance freelance writer. A former senior industry specialist with Standard & Poor's and managing editor of ColoradoBiz magazine, he has also written for The Denver Post and American Express.