Financing from Family and Friends∗

We present two models in which a family investor differs from a non-family investor only in that she has an altruistic relationship with the entrepreneur who seeks financing. We show that because of this single difference, family finance is a source of trust capital whereas formal finance is a source of risk capital. Both deepen the financial market. Family finance has two drawbacks: Risk remains in the entrepreneur’s social sphere and exposes his social relations to negative feedback effects, both deterring risk taking. Our models emphasize crucial differences between legal liability and social indebtedness and shed light on the dearth of growth finance in developing countries. Based on these insights, we propose a method for providing microventure capital. ∗We thank Xavier Gine and seminar participants at the 2012 AEA Meeting for helpful comments. Samuel Lee (corresponding author), Stern School of Business, New York University, KMC 9-71, 44 W 4th Street, New York, NY 10012, [email protected]; Petra Persson, Columbia University, Department of Economics, 420 W 118th Street, MC 3308, New York, NY 10027, [email protected].