The Cold, Calulating Way to Invest in a Friend's Business

Last Updated May 26, 2011 1:44 PM EDT

Entrepreneurs understand that when it comes to funding a venture, friends can be a good and even willing source of capital. The money is available quickly, probably at decent terms and the board meetings aren't too fractious.

But what's the view from the other side? Should you even consider investing in a business being started by a friend, spouse, child, neighbor or church elder?

Before answering, read a cautionary tale of woe from Whitney Johnson, herself a professional VC, who went in on a friend's business. "My husband and I lost a painful lot of money. It was devastating," she writes on HBR.org.

Johnson's goal is not to discourage friend investing, but rather to advise an analytical, unemotional approach.

She offer these three tips:

  1. Set clear boundaries. Just because a friend is involved, don't short-change yourself on terms. You have a fiduciary responsibility to your family (assuming you are putting family capital as risk), so negotiate an amount of risk-versus-reward that you are comfortable with.
  2. Establish rules of engagement. The tendency is to say, "We'll figure this out as we go along." But no VC would ever give money on that basis, and you shouldn't either. The startup needs a clear business plan, details on roles and responsibilities of the officers, and a written understanding of who has ultimate veto power.
  3. Accurately assess your partners. A SWOT analysis (Strengths, Weaknesses, Opportunities, Threats) is usually performed as a business sizes up its market position. Johnson recommends doing a similar analysis on the friend you are investing with. Does she manage people well? Is she a strategic thinker? Can she perform under pressure?
Johnson's new bottom line on buddy bankrolling? "Friendship-cum-philanthropy comes second; financial savvy and safety, first."

Have you invested in a friend and regretted it ever since? What went wrong, and what did you learn from the experience?

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(Photo by Flickr user AMagill, CC 2.0)
  • Sean Silverthorne

    Sean Silverthorne is the editor of HBS Working Knowledge, which provides a first look at the research and ideas of Harvard Business School faculty. Working Knowledge, which won a Webby award in 2007, currently records 4 million unique visitors a year. He has been with HBS since 2001.

    Silverthorne has 28 years experience in print and online journalism. Before arriving at HBS, he was a senior editor at CNET and executive editor of ZDNET News. While at At Ziff-Davis, Silverthorne also worked on the daily technology TV show The Site, and was a senior editor at PC Week Inside, which chronicled the business of the technology industry. He has held several reporting and editing roles on a variety of newspapers, and was Investor Business Daily's first journalist based in Silicon Valley.