C.J. Burton

Where do start-ups get the money to start up? Friends, family and fools.

It's an old joke, but it neatly sums up the conventional wisdom about the risks of investing in a loved one's business. Not only do you stand to lose your money, you could lose the relationship if the company goes belly-up, or even if it just goes through the regular stresses of getting a venture off the ground.

The conventional wisdom has a lot of truth in it, as countless failed businesses—and relationships—will show. But things don't always end in disaster. There are rare cases that pay off for everyone—even spectacularly.

In fact, some of the biggest small-business success stories started with a friend or relative taking a big gamble on a loved one's business that looked like a losing proposition. Their tales offer insight and hope for those who are about to write a big check, or ask for one.

Here are their stories.

How Do You Say No to Your Daughter?

Peter Levy admits he should have known better. A former Goldman Sachs banker, and later an executive at a fund of hedge funds, he knows how to take a clear-eyed view of an investment opportunity. When approached in early 2000 about investing in an email newsletter for shopping tips, he was skeptical.

"I would rather invest in oil or steel or something I understand," the 76-year-old Mr. Levy recalls thinking, adding that he barely knew how to use a computer at the time.

There was one problem: The aspiring entrepreneur was his daughter, Dany. A magazine editor in New York, Ms. Levy was approaching burnout at her job. She wanted to quit to launch the newsletter, which would provide subscribers with insider tips on sample sales, hot restaurants and upcoming events. She called it Daily Candy.

To demonstrate the power of the Internet, Ms. Levy, now 39 years old, sat with her father—an avid antiques shopper—at the computer and showed him a popular new website called eBay.

"It was very cute, actually," she says of watching her father discover the treasures of the Internet.

Mr. Levy agreed to bankroll the business, writing a check that Ms. Levy says was more than her annual salary at the time.

For his part, Mr. Levy acknowledges he wouldn't have invested if the pitch came from anyone other than his daughter, but insists he was going on more than blind faith. Ms. Levy was notoriously frugal—she once wrote a magazine story on "How to Be Cheap"—and he felt confident that trait would translate to the business world.

"One thing you need in any business is someone who can operate and knows how to control costs," Mr. Levy says.

He says they talked about the fledgling business regularly, over dinner and in casual conversations, but he realized he was too far removed from his comfort zone to provide specific advice about operations. "I just didn't understand it," he says. "It was out of my expertise level."

But he was able to connect her with a friend, a Wall Street banker, who was experienced in dealing with start-ups. Ms. Levy says the banker invested invaluable time with her helping her understand the financial intricacies of scaling a young business.

Even so, disaster struck. A website designed to complement the newsletter was a technical disaster and had to be rebuilt almost from scratch. Confident in his daughter's abilities, and determined to remain hands-off, Mr. Levy didn't intervene as she burned through the initial investment. Ms. Levy, in turn, was not comfortable asking him for more money.

She tried to explain it, but I just went on faith. She's a smart girl.

——Catherine Goldschmidt on bankrolling her daughter's online venture, Daily Candy

As she got increasingly persistent collection calls, she reluctantly solicited an additional investor: her mother, Catherine Goldschmidt, who was divorced from Mr. Levy. Ms. Goldschmidt says she was happy to contribute even if, like her ex-husband, she didn't fully understand the business. "She tried to explain it, but I just went on faith. She's a smart girl," says the 64-year-old Ms. Goldschmidt.

Ms. Levy recalls standing at the teller window, her mother's check in hand, with tears streaming down her cheeks. "I was always terrified that I would lose their money," she says.

That check kept the business alive, and it subsequently took off—first as a trend spotter for New York's most fashionable and then later as a lifestyle tip sheet for women in cities from coast to coast. Ms. Goldschmidt says she pitched in when she could—helping put together promotional goodie bags that Ms. Levy passed out on the Hamptons jitney, on one occasion—and asked if she could invest more as the business grew. Ms. Levy demurred.

In 2003, investment group Pilot Group Ventures bought Daily Candy for $3 million. Ms. Levy's parents collected about four times their initial investment, but the exit was not without tension: They wanted to maintain their investment in the company, and possibly even increase it, but Pilot insisted that Ms. Levy remain as the only outside shareholder. In 2008, Pilot sold Daily Candy to Comcast Corp. for $125 million.

Ms. Levy, who's no longer at Daily Candy, says she is grateful that she didn't need to solicit her start-up capital from strangers. Angel investors and venture capitalists will "breathe down your neck," she says. Instead, she believes entrepreneurs should seek money "from people who believe in the entrepreneur and the idea—and aren't going to get all up in their business."

Ms. Goldschmidt is investing in her daughter's new venture, an iPad magazine called Punch. But this time she consulted her financial adviser before she wrote a check.

"He said, 'She's got a good track record—go ahead,' " Ms. Goldschmidt recalls.

Mr. Levy, who's also investing in Punch, says he has only one regret about the Daily Candy experience: "I wish I put more money in."

Can They Pull It Off This Time?

Sometimes entrepreneurs aren't planning to turn to their family and friends but end up with little choice.

When brothers Kai and Charles Huang decided in 2001 to launch their own business, shortly after the dot-com bubble burst, investor money had all but dried up. "Things were pretty spare" in Silicon Valley, says Charles, now 42.

So, the brothers turned to the Chinese-American community in Northern California, including their parents, uncles and friends from college and elsewhere. Unlike Ms. Levy, who approached her parents very informally, the Huang brothers drew up a 15-page business plan that included a valuation for the company and a blueprint for how they intended to build a business that would be like Netflix, but for videogames.

In all, they raised a total of about $1.8 million, including about $150,000 from an uncle in China who does not speak English or use email.

John Cheong, a friend who invested $50,000, had previously declined to put money into a software venture the brothers started and essentially broke even on. This time, Mr. Cheong was persuaded to buy in largely because Kai was willing to try again rather than return to his promising career in consulting. "He can't be that stupid," Mr. Cheong recalls thinking.

For about the first five years, it appeared Kai and the investors might have made a bad bet. The company almost went bankrupt on three different occasions, and the Huang brothers took out second mortgages and more than $100,000 in credit-card debt as the business floundered.

"That is the funny thing" about having friends and family as investors, says Kai, now 39. "You see them all the time. Inevitably, the question comes up: How is the business going?"

The answer was, not good. The brothers changed business models multiple times, and showed small signs of gaining traction only when they shifted to selling accessories for videogames.

One friend and investor, Michael Cheng, admits he cut the brothers some slack while they struggled because he knew Charles from their undergraduate days at the University of California, Berkeley, and they later traveled together through China.

"If I was an institutional investor, the alarm bells might have been going off and 'measures' might have to be considered," says Mr. Cheng, who was a graduate student when he invested.

In 2004, the brothers decided to get into the publishing side of videogames with a variation on the music games that were hugely popular in Japan. They partnered with a game developer to create the software, while they handled the accessories for the game—which they called "Guitar Hero."

But their hardware costs alone were almost $3 million—money they did not have. Meetings with venture capitalists were fruitless.

They are very talented and hardworking. I wanted to make life easier for them. Love will make you overlook anything.

——Amy Chen on her neighbors' kids, the team behind "Guitar Hero"

At their parents' house one day, they told a longtime neighbor, Amy Chen, about their financial dilemma. Ms. Chen, now 68, had just refinanced her home and had some money available. She says she considers the brothers like her own sons, and she didn't think twice about writing them a check for almost half a million dollars. "They are very talented and hardworking. I wanted to make life easier for them," she says. "Love will make you overlook anything."

With that check, they were able to launch "Guitar Hero," which went on to become a hit of the 2005 Christmas season. By early 2006, they had larger companies interested in buying them out.

Looking for advice, Charles called Mr. Cheng, who asked about the valuation the companies were proposing. "I almost choked on what I was drinking at the time," Mr. Cheng says. His advice: "Run, don't walk, to the bank" to make the sale.

In May 2006, their company, RedOctane, was sold to the company now known as Activision Blizzard Inc. for a reported $100 million in cash and common stock. The brothers are contractually bound not to discuss the terms, but Kai says the investors "did very well and were extremely happy with the outcome."

"When it comes to family reunions, we are a lot more popular," Charles adds. "It wasn't that we made a bunch of money for some faceless investment fund. That was extra gratifying."

Most of the investors were fairly affluent already, they say, but one used the proceeds to buy a home in Palo Alto.

Ms. Chen, who did not get equity in the business, says the brothers paid her back with 10% interest—money she tried in vain to return. One downside for her about the sale: The brothers' parents bought a house in a new neighborhood. "I miss them dearly," she says.

The windfall also enabled Mr. Cheng to start his own investment fund in Shanghai, where he now lives. Not long ago, Charles told him that "Guitar Hero" was on track to become the first videogame to break $1 billion in sales and commented that they may have sold too soon.

Mr. Cheng replied, "I wonder what idiot told you to sell!"

Do You Buy a Sports Car, or Invest in a Coffee Bar?

Robert Okabe, president of the Angel Resource Institute, which provides advice and training to early-stage investors, has this advice to anyone looking to invest with a friend or family member: Keep the amount to a number that wouldn't hurt if you lost it. "If you are giving $50,000 to a friend and you are only worth $5 million, it means a lot more," he says.

Ron Margolis went that route. A prosperous Seattle obstetrician, he was planning to spend a six-figure sum on a Ferrari one day in 1985 with the proceeds of a successful stock trade. But his wife recommended he meet instead with a friend's husband about an investment opportunity. The budding entrepreneur, Howard Schultz, was looking to start a chain of coffee shops called Il Giornale, modeled after the coffee bars he had seen in Italy. Dr. Margolis liked the idea.

"He was a nice Jewish boy, and I was kind of a nice Jewish doctor," Dr. Margolis recalls. "I said, 'OK, Howard.' I wrote a check for a quarter of a million dollars."

Mr. Schultz asked him if he knew other prospective investors, and Dr. Margolis promised to ask around. He says he approached 40 other doctors—all said no. Nevertheless, the company grew rapidly and eventually acquired another coffee chain with a better name: Starbucks.

For Dr. Margolis, now 70 years old, losing the money would not have changed his lifestyle, but the check was not a favor, either. He says he sized up Mr. Schultz with a simple set of criteria. "Is the person honest? Does the person have a great passion for what he is doing? Is it simple enough for me to understand what the person is proposing?" he says. "There are so many people that are so clever and have all of these clever ideas, but I don't understand them. I could understand a coffee shop."

Since Starbucks, he has invested in about 20 other start-ups using those guidelines. Only three made any money.

He was a nice Jewish boy, and I was kind of a nice Jewish doctor. I said, 'OK, Howard.' I wrote a check for a quarter of a million dollars.

——Ron Margolis on Starbucks mastermind Howard Schultz

Dr. Margolis served on the Starbucks Corp. board of directors for several years—where he says he was not shy about voicing his opinions—but has had no role at the company for more than 20 years.

"Howard asked me to leave. I was too much of a troublemaker," Dr. Margolis says. Mr. Schultz declined to comment, through a Starbucks spokesman.

Dr. Margolis, who now lives in Tucson, Ariz., with his second wife, has no hard feelings and says he had a warm meeting with Mr. Schultz recently in Seattle. And why should he be angry? His investment in Starbucks earned him tens of millions of dollars, and the company's success has enabled him to put money aside for his daughter, a schoolteacher.

Dr. Margolis says he still owns most of his Starbucks shares. In fact, he professes not to know what they are worth: "It is just a number in an account."

Mr. Reagan is a news editor in The Wall Street Journal's New York bureau. He can be reached at brad.reagan@wsj.com.