Lloyd Steier holds a research chair and is a professor in the department of strategic management and organisation at the University of Alberta School of Business. He is also the academic director of the Centre for Entrepreneurship and Family Enterprise and the Alberta Business Family Institute.
The perils of borrowing and lending are well documented, especially when it comes to family and friends. However, there are ways to do it successfully and encourage innovation – without endangering relationships. Lloyd Steier describes how to do it
An admonition, found in William Shakespeare's Hamlet is sound advice for leading one's life: "Neither a borrower nor a lender be; For loan oft loseth both itself and friend." Implicit in the message is the notion that mixing money matters with personal relationships often leads to troublesome outcomes. Family members often find themselves in the position of borrower or lender to one another, particularly in the early stages of venture development. While this can have catastrophic results for both families and businesses, family investment can also play an important role in nurturing family members and in successful venture creation.
Every gift of money or lending situation has a particular structure, ranging from formal, written contracts to informal, unwritten agreements. The form and structure of financial deals involving family members has important implications for the survival and success of the venture as well as family relationships. Often, misunderstandings and misalignment of goals in structuring deals between family members lead to disputes. When deals go bad – and sometimes even when deals go good – family relationships are strained as sensitive decisions are made over the allocation of resources.
Motivations for family banking
Family is often thought of as a last resort after failing to raise money from outside sources. Without family resources and confidence a lot of successful business ideas could never have been realised. However, entrepreneurs often rely on their families for financial assistance for many reasons. Less formal family arrangements and greater levels of trust between parties allow the entrepreneur to exercise tighter control over the operation and management of the venture. Outside money often comes with too many strings attached. Also, dealing with family members usually involves lower transaction costs than arrangements through financial institutions or venture capitalist firms. Some entrepreneurs simply desire to retain profits within the family. Family can also provide valuable resources beyond venture capital such as emotional support, mentorship, and connections.
Whatever the motivation, when family members invest in the ventures of other family members, they must make choices – either explicitly or implicitly – about form and governance in structuring the deal. In recent research at the University of Alberta School of Business we developed a framework for classifying family-financed deals along a continuum between relatively loose, informal and altruistic family affairs and more rigid, market-based business contracts.
At one extreme, family deals follow a rational economic approach. Investment decisions are guided by financial criteria and ultimately motivated by profit. For example, some families have been known to pool their money and operate sophisticated venture capital funds. Entrepreneurs submit business plans that then undergo feasibility analysis. Family ties merely guarantee that a loan application will be considered.
At the other extreme, transactions are handled informally and characterised by an absence of documents detailing agreement between parties. For example, there may be an unspoken understanding that the money need not be repaid if the venture fails and that payments may be delayed in times of financial strain. Rather than seeking a targeted return on investment, the lender acts on an altruistic motivation based on love, trust, and the desire to help a family member.
Family-financed arrangements rarely fit neatly into either end of the spectrum. Family-based enterprises have unique governance contexts in that they typically attempt to address the overlapping, and often competing, concerns of the family and the business. Family concerns incorporate altruistic values and revolve around nurturing and development of family members while the business side is typically concerned with survival and profit. This creates an ambiguous dynamic of seemingly opposite "selfish" and "selfless" motives that complicate the management process.
It is this lack of clarity that leads to a gap in understanding and expectations between investors and investees. What happens if the loan can't be repaid on time – or at all? Will money "gifts" spark jealousy and rivalry among siblings? Who will keep track of how the money is managed and used? With so many overlapping considerations, it is easy to imagine how both businesses and families can be destroyed without proper attention to structuring financial deals.
An unhappy success story
Most readers can think of their own examples of families strained by deals gone bad. The media is full of stories of these business disasters. However, as the following case illustrates, successful business outcomes can also lead to problems.
After struggling for several years, an entrepreneur sold his company for a substantial profit. During the "lean years" he often relied on family members for support: they provided loans when he was turned down by bankers and other lenders; family were also "emotional cheerleaders" for the enterprise and some even used their social and work connections to help the entrepreneur. Other forms of support included a place to stay, free labour, vehicle loans, and paying for restaurant and entertainment functions. When he cashed in the entrepreneur repaid all of his financial loans at a rate of return much higher than originally agreed. Despite this perceived generosity on the part of the entrepreneur, a number of family members remained unhappy and felt that they were entitled to an even greater share of the profits. According to the entrepreneur, fulfilling family expectations had become one "big hassle" that he was ill-prepared to deal with.
The story highlights how the ambiguous motives of family altruism and business profit come into play and can shift over time. Family was a source of resources and funds during the early stages of firm creation. So the unexpected windfall profit at the exit stage and differing perceptions about what everyone's contribution and fair share should be created conflict. Notably, understandings of the deal shifted over time. The entrepreneur relied heavily on familial altruism to secure resources at the early stages of his venture but later subscribed to a stronger economic rationality when distributing rewards. Supportive family members were motivated by altruistic motives during the early stages of the venture. Family members may have been happier with a more modest success.
Striking a balance
As the case illustrates, whether the new venture results in failure or success, disputes often arise because of ambiguity surrounding the terms of the deal. Problems often stem from agreements that are unwritten, incomplete, or vaguely worded. However, there are advantages and disadvantages to both formal and informal deal structures. Family social relationships or relational contracts can complement or substitute for more formal governance mechanisms. Indeed, they can provide a new venture with several advantages over non-family enterprises.
A long-term stake in family resources and the possibility of disapproval, chastisement or rejection by other family members can act as a powerful incentive for entrepreneurs to act in the best interests of the family. Selfless altruistic motives and loyalty prevent family members from taking advantage of each other. High levels of trust can reduce monitoring and compliance costs for a business.
Also, sharing private and work lives can result in greater transparency of work, ethic, attitude, contribution to and consumption of resources. On the other hand, some disadvantages of informal family arrangements include conflict in private life affecting business relationships and "free-riding" by family members.
As a lender or a borrower how do you manage the delicate balance between familial altruism and business rationality? Structuring financial deals on either extreme of the continuum may be unwise. The optimal mix will depend on the nature of the family relationships and the personalities. Nonetheless, it is critical to avoid the confusion and ambiguity that often lead to conflict later on. A good start to forming your deal is understanding the expectations of the other party. Previous research in the fields of angel investing and venture capital recognises six key elements of the investment process. Before any money exchanges hands, we suggest these six elements be clarified by both lenders and borrowers.
In determining the form and structure of family-financed deals, it is important to identify and understand the primary governance mechanism to be used. Family investment activity is governed by arrangements ranging from altruism and trust to market-based rationalities. Most relationships are a hybrid forged from these two templates. When the governance mechanism is not clear to stakeholders, it can shift over time and lead to disastrous results for both family relationships and the business. Success for family-financed ventures hinge on mutual understanding of the six key elements of the investment process. Open communication will decrease the dissonance between borrowers and lenders and prepare both parties for success or failure.