Friends and Family Investors: The Dangers Startups Must KnowStartup Law ResourcesVenture Capital, Financing
Before raising money from friends and family, there are a few legal aspects that startups must know about security laws and potential legal issues.5 min read
Over one-third of startup founders have raised money from friends and family. In fact, startups receive more than $60 billion dollars per year from these investors. That's more than angel investors and venture capitalists combined.
Raising money from friends and family has several advantages. They're often more willing to invest in you personally while a larger investor might demand to see a firmly established company. You also might be able to avoid the complex compliance requirements that come with other securities sales.
However, there are many things you need to be cautious about before you take money from friends and family such as:
Valuation and Structuring Problems
Early-stage startups frequently offer friends and family investors large equity shares at a valuation an unrelated investor would never accept (e.g., selling stock at $1 per share with 10,000,000 shares outstanding which values the company at $10,000,000). This makes it difficult for an angel investor to come in at a fair value and fair share in a later funding round.
If this happens, you'll should restructure your company and reallocate equity among friends and family so that everyone ends up with a number of shares they should have owned if the friends and family investors invested at a fair valuation. In addition to bad feelings, overvaluation can lead to very costly legal and tax consequences.
To avoid this problem, you should bring in all investors at a fair value from day one. Since a typical pre-money valuation for angels would be between $1 and $3 million, in general the maximum pre-money valuation from friends and family should be between $250,000 to $1 million. A typical amount to raise from friends and family is $25,000 to $150,000.
Friends and family investments aren't made outside of securities law. They just happen to almost always fall within an exemption. Before asking for investments, be sure to familiarize yourself with any limits under securities law, including on the dollar amounts raised, the number of investors and how you ask for investments. You also may have to follow the "blue sky laws" which are individual state's laws that generally regulate the number of unaccredited investors, the level of "sophistication", and the information that needs to be provided.
Two general rules you should remember are:
You must provide full disclosure to your investors through a prospectus (a combination of the terms of the investment and financial information about your company) or some other means so that they can make an informed investment decision.
You must register with the SEC unless you are following the requirements of a specific exemption.
Asking for Too Much Money From Those Who Cannot Afford to Lose It
Never allow friends or family to invest their life savings or drain their retirement account, even if they are willing. This kind of personal risk puts too much pressure on you to return their investment. Only accept what they can afford to lose no matter your level of confidence.
Also remember that our wealthiest friends and family members may not always be the best investors. A smaller investor with the experience or connections you need to grow can help you much more.
Overly Involved Investors
Friends and family members who aren't experienced investors may ask you for constant updates or expect to make business decisions. While it's good to keep them informed, they shouldn't interfere with your daily operations. Business decisions should never be made through peer pressure.
Create a shareholder agreement that outlines voting rights and board representation. Only allow greater involvement if an investor has specialized experience or expertise that you value.
Put in Your Own Money
Outside investors and lenders (including your family and friends) often like to see that you've invested your own capital. This gives you skin in the game and increases your incentive to protect your own investment by avoiding unnecessary risks and reducing wasteful spending.
When investing gets personal, this is even more important. If you share in a potential loss, your friends and family will be less likely to feel cheated if they lose part of their investment.
Having a Weak Business Plan
Don’t make the mistake of having a weak business plan, even when dealing with friends and family. One of the downsides to having individuals invest in you rather than your company is that they may not challenge your business plan to the same degree. While this may seem like less work for you to do, it's not a good thing.
As in situations in which you're entirely self-financing, a strong business plan is your road map for the future, ensuring that you've thought through the hurdles you may face.
Similarly, you are best off if you have a prototype to share with your friends and family in addition to the business plan.
It's good to be enthusiastic and even confident, but never over-promise. Your friends and family investors should fully understand the risks, including that 90 percent of startups fail.
This isn't just about controlling expectations and protecting relationships — it can also protect you legally.
While not common, an investment gone bad can lead to accusations of breach of contract or even fraud. Putting the risks into a written prospectus will give you additional protection if you're ever taken to court.
Types of Security
One popular option is to use a convertible note (a loan that can later be turned into stock) for the friends and family financing round. Many also include a cap on the valuation so you do not need to worry about the price of the investment - for example, a 20-25% discount from the next round and a 10% valuation cap.
Straight equity or loans (and even gifts) are other possible funding options from family and friends.
If your business struggles and you aren't able to return your investors' money, bad feelings may arise. There is an even greater risk if you're paying yourself a salary or don't use personal financial windfalls to repay investors.
Even when you and your investor feel comfortable with an informal agreement, it's critical to spell out your mutual expectations. Think of it like a prenuptial agreement before marriage. If you plan for the possibility of something going wrong, it's less likely that small business losses will turn into big personal losses.
You may even want to set up repayment terms with a promissory note that details how long it takes to get money back and at what interest rate. As noted above, If they're interested in equity, consider using a convertible note.
Other Options for Raising Money
If you are unsure if you want to raise money from your friends and family, you may want to consider approaching more institutional investors such as angel investors and venture capitalists. Make sure you read our guide on angel investors and what startups should prepare for as well as our guide on venture capitalists.
Hiring a Lawyer
If you want to ask for investments, it's a good idea to hire a lawyer. From securities regulations to investor agreements and other business law issues, there are many things that can go wrong. Even if you think you can research everything you need to know, there's a good chance you'll miss something that would be obvious to an experienced attorney.
UpCounsel has a directory of highly qualified attorneys with an average of 14 years of experience. They're available on-demand to help you stay within your budget now. Search now to find an attorney near you.