Financing from Family and Friends

52 Pages Posted: 19 Jun 2012 Last revised: 11 Sep 2015

See all articles by Samuel Lee

Samuel Lee

Santa Clara University - Leavey School of Business; European Corporate Governance Institute (ECGI); Swedish House of Finance

Petra Persson

Stanford University; Research Institute of Industrial Economics (IFN)

Multiple version iconThere are 2 versions of this paper

Date Written: September 10, 2015

Abstract

The majority of informal finance, in developed and developing countries, is provided by family and friends. Yet existing models of informal finance better fit “informal moneylenders” insomuch as they fail to match two salient characteristics of family finance: family investors often accept below-market or even negative returns, and despite this, borrowers tend to prefer formal finance. We explain both of these characteristics in a model of external financing that allows for social preferences between relatives or friends. The social preferences make family finance cheap but also create shadow costs that nonetheless discourage its use: Committing family funds to a risky investment crowds out familial transfers in low-consumption states, and undermines limited liability. The very characteristics that generate intra-family insurance thus render family finance a poor source of risk capital. In contexts where contracts must harness social ties to overcome capital constraints, our findings suggest that third-party intermediation and semi-formalization may be crucial for promoting risky investment. This is relevant to the limited success of group-based microfinance in generating entrepreneurial growth, and to the emergence of social lending intermediaries and crowd funding.

Keywords: Informal finance, family loans, peer-to-peer lending, small business lending, entrepreneurial finance, microfinance, missing middle, financing gap, risk capital, social ties, altruism, social collateral

JEL Classification: G32, G21, O16, O17, D19, D64

Suggested Citation

Lee, Samuel and Persson, Petra, Financing from Family and Friends (September 10, 2015). NYU Stern Working Paper FIN-12-007, IFN Working Paper No. 933, ECGI - Finance Working Paper No. 358, Available at SSRN: https://ssrn.com/abstract=2086625 or http://dx.doi.org/10.2139/ssrn.2086625

Samuel Lee (Contact Author)

Santa Clara University - Leavey School of Business

500 El Camino Real
Santa Clara, CA California 95053
United States

European Corporate Governance Institute (ECGI) ( email )

c/o the Royal Academies of Belgium
Rue Ducale 1 Hertogsstraat
1000 Brussels
Belgium

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Petra Persson

Stanford University ( email )

Stanford, CA 94305
United States

Research Institute of Industrial Economics (IFN) ( email )

Box 55665
Grevgatan 34, 2nd floor
Stockholm, SE-102 15
Sweden

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