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Startup Financing - The Friends and Family Round- Avoiding the Pitfalls
The Friends and Family financings are always the easiest to execute, and provide the most important first layer of startup financing. Friends and Family rounds usually raise $25,000 to $150,000 in total – the amount depends a lot on who your friends and family are.
The only problem is that most people who invest in Friends and Family financings usually shouldn’t.
Professional investors agree that startup financings are the most challenging. At the startup phase, companies don’t usually have financial statements or even complete corporate structures. There is often no way to accurately determine the state of the intellectual property, fair valuation or reasonable terms. Most startups just can’t afford to pay good lawyers to properly structure the corporation, prepare the investment contract or even draft the subscription agreement.
Even worse, the younger the company, the more likely it is to fail. Even after the VC rounds about 60% of the companies fail after receiving financing. At the startup financing phase the failure rate is over 90%.
So this is the most difficult time for our unsophisticated friends and family members to be making an investment decision - and odds are they will end up with a tax loss.
So why are they investing? Because they trust at least one of the entrepreneurs. That’s one of the reasons Friends and Family investment is also often called “love money”.
Entrepreneurs should remember they will be sitting around the dinner table with their friends and family for a long time – possibly for the rest of their lives. This entire process is fraught with risk and potentially grievous relationship consequences.
So why do the entrepreneurs do this? Because they believe. And they really need this early capital. And nobody else is likely to invest at these very early stages.
Unfortunately, I often see F&F financings that have gone horribly wrong. In every case I can think of, both the entrepreneurs and investors were well intentioned, but nobody involved with the financing had the experience and knowledge to properly incorporate all of of the essential elements needed for a successful transaction.
What can entrepreneurs do to make sure they are treating their friends and family fairly and also ensure the highest probability of a positive outcome?
The most important elements in avoiding Friends and Family pitfalls are:
- Fairness
- Alignment and
- Governance
Each element must be built into the structure of the company and the very first financing agreement.
Fairness encompasses structuring elements including valuation and terms. Alignment includes vesting, founder compensation and the type of shares. Governance includes a capable, engaged, properly aligned and motivated board.
