High-net-worth clients are frequently approached by family members and friends to invest in startup companies. Advisors know this is an extremely risky investment, yet the emotional tugs often overwhelm rational risk management. The risk—and not just to capital—of friends and family investing may be even higher than was thought. This article was adapted from the book What Every Angel Investor Wants You to Know: An Insider Reveals How to Get Smart Funding for Your Billion Dollar Idea (McGraw-Hill) by Brian Cohen and John Kador.

For most startups, the first source of funding is the people closest to the entrepreneur. This makes perfect sense. It’s easiest to approach the people who know them best and want to believe in entrepreneur the most. After all, trust has been established. They know the person and often know their work ethic. They want to be helpful. In many cases, such investments are more like gifts than true debt that has to be repaid.

According to the Global Entrepreneurship Monitor (Babson College and the London Business School), friends and family investing annually accounts for $50 to $75 billion in early stage capital in the United States. This is two to three times the amount of money invested annually by either angel investors or venture capitalists. I always encourage entrepreneurs to consider all potential levels of financing, from the very beginning through to the exit.

The only problem is, entrepreneurs rarely treat this first investment with rigor, thoughtful professionalism and legal discipline. Unfortunately, what happens is that friends and family, the people who deserve the best outcomes, don’t get the benefit they deserve and in many cases get financially hurt. I get very upset when I see this, because these are the people who take the biggest risks and should receive the best returns.

It’s usually a misnomer to say that friends and family have invested in the founder’s business. It’s almost always the case that they have invested in the founder. After all, they are impressed by their loyalty, integrity, proven smarts, demonstrated work ethic, curiosity, intelligence, and all around excellence. They are willing to invest in the entrepreneur because they care. This reality creates the potential for a number of problems, and one needs to be aware of the risks. In too many cases, it’s not clear whether the money is a gift or a loan.

One of the chief risks is that emotions may get in the way of what is, after all, a highly speculative business transaction. When friends and family investments are structured well, everyone wins. If the founder makes his or her numbers and go for an angel or later venture capital round, everyone can be happy. But unfortunately too many entrepreneurs don’t think the process through and unintentionally hurt the ones who love them most.

The issue is that although friends and family money is real money, too many entrepreneurs tend to think of it as money that doesn’t have to repaid. To be fair, many uncles and brothers-in-law and former college roommates provide funding without clear agreements.

Is the money a loan? A gift? The paperwork governing the terms of repayment somehow never gets completed. I’ve heard some founders say, “My aunt will sign anything I put in front of

her.” I’ve seen too many cases where family is mistreated. You’d think that this would be a huge problem, with stories of millions of conflicts between friends and family investors and the founders they supported. In fact, such stories are not hard to find. But the reality is that these kinds of squabbles are actually less common than you might think. That’s because so few startups succeed.

In other words, the potential for squabbling arises only when a startup is acquired or exits through an IPO and there are considerable sums to be doled out to investors. When there’s nothing left to fight about, the lack of agreements rarely becomes an issue.

Manage Expectations

I believe that it’s the entrepreneur’s responsibility, as a founder, to treat the ones who love him professionally. It’s better for everyone to treat it as a business relationship. The failure to treat these investments with the same precision as they would angel or VC money will not only ruin family Thanksgivings for years to come, but it will complicate and even derail subsequent rounds. To manage the investor’s expectations, founders have to start by managing their own. They can start by being principled.

There are strict laws regulating investments in risky ventures (and there are few ventures more risky than a startup). These rules govern who may or may not invest and what information entrepreneurs need to give them before they invest. A lawyer is helpful every step of the way.

Most founders don’t realize that raising money is an ongoing process and that they will need successive rounds of capital-raising as the startup evolves. I like to see startups get smart about raising money as early as possible, not just as a singular event but as an ongoing part of the evolution and development of their business. If they do, it’ll make the angel rounds much easier.

Accepting money from friends and family can be fraught with difficulties. My own take on accepting friends and family money is based less on the sophistication of the entrepreneur than on the sophistication of the individual approached to invest in a friends and family round. Here’s the test: Is the friend or family member savvy about business practices? Does she have significant investments in the bond or equity markets?

Is she an active trader? Has she established a track record of investing in family opportunities, and has she developed formal practices for documenting those investments? Is she advised by a neutral lawyer, accountant, or tax advisor?

There are no guarantees, but if the entrepreneur is dealing with someone sophisticated in financial matters and who is well-advised, then I think accepting friends and family money is warranted. If in doubt, the entrepreneur should seek money elsewhere. It will be more expensive in the short run, but trust me, the entrepreneur can’t afford cheap money that puts dear relationships at risk.

Brian Cohen is the chairman of the New York Angels, an independent consortium of individual accredited angel investors, providing seed and early-stage capital. John Kador is the author of 15 books and a frequent contributor to REP. For more details, visit www.getfundedbyangels.com.