Friends and Family Round Basics

No one is made of money. Make their investment count.

Most startups are founded with money from the entrepreneur’s family, friends, or significant others.  This round of funding is commonly referred to as the “Friends and Family” round (although some professional investors change it to “Friends, Family, and Fools” to reflect the lack of sophistication most seed-stage investors have).  The Friends and Family (”F&F”) round is typically designed to just get the idea rolling: a proof of concept, a formal design, or something else of substance that would advance the idea towards a more viable form that would interest a more sophisticated investor.

Formalize it!

Because this source of funds is usually someone close to the entrepreneur, there is frequently little formality around the investment.  This should not be the case as it creates potential issues down the road.  The required documents can vary, depending on the investment type, the state, and a number of other variables, so consult an attorney.  The cost will be greatly justified down the road.

Deciding on what structure to use when raising funds can be tricky for new entrepreneurs.  Most people either take the money as a personal loan or decide to give up equity in the new venture.  Either of these can be a good option, but there is another option that should be considered: the convertible debt note.

Convertible Debt Notes

It may sound scary if you’re unfamiliar with the concept, but you will find it has enormous advantages over the other two options.  First of all, it’s a loan… to the company.  Your personal assets aren’t on the line, so if (perish the thought) the company should default, the investor cannot come after your house, car, and you fancy flat-screen.

The next advantage is that you don’t have to place a value on the company to execute the investment.  This is probably the biggest reason the professionals use this instrument.  Valuing an early-stage company is a black art at best, and is more realistically, just a guessing game.  An equity investment would require you to look deep in your crystal ball and value the company now so you can determine how much equity to give the investor based on his investment, whereas a convertible debt note is just a loan to the company, which can convert to equity AFTER a REAL value is assigned.

This leads us to the third benefit to convertible debt notes: alignment of interests.  The investor gets the security of knowing that he’ll have first claim on the assets of the company, should anything go wrong, which will motivate you; you get to receive your capital without having to value the company or give up equity too early; and everybody gets to participate in the up-side if things go very well for the start-up.

Consult an attorney who has specific knowledge in securities law to help you design the convertible debt note.  He/She can guide you through the process of setting up the triggering event, determining a discount schedule, and the vast array of other moving parts that can be present in such an instrument.

Follow the rules

Once you have determined what securities you’re going to issue, and you have your documentation in place, you’re ready to accept checks.  Be aware that you can really only take money from people with whom you already have a relationship, unless they are an “Accredited Investor”, the definition of which is spelled out very clearly by the SEC.  Also be aware that you cannot just spam the internet looking for Accredited Investors, because the SEC has an issue with that too (It’s called “General Soliciation” and it’s a no-no according to Rule 502(c) of Regulation D).  Again, check with an attorney to make sure you’re doing everything legally.

Don’t forget them

Ok… you got your first big chunk of change to get your dream start-up off the ground.  Nice work!  Now remember that this money you took comes with strings.  You need to keep your investors up-to-date on major goings-on with the company.  Did you hit a major milestone?  Sign a new distribution agreement?  Have a technological breakthrough?  Send an email telling them about it!  You will always have to be updating investors, so you should start early with the ones that got you going.  It’ll make them feel good about their investment, and it will keep you in their good graces in case you need to come back to them to raise more money.