Avoiding the pitfalls of raising money from friends and family

By Michael Carney , written on November 28, 2013

From The News Desk

Ah, the holidays. What better time to make bad decisions regarding the people that love you and know you best: your friends and family. And for an entrepreneur, that all too often means hitting them up for early startup funding. “Friends and family rounds” of funding aren’t inherently bad, but they can be if not handled thoughtfully.

Such rounds are typically between $25,000 and $250,000, but this varies on who’s in your personal rolodex and family tree. They have presumably been the early lifeblood of many successful companies (although none spring to mind) and can be a good way for founders to share their potential future success with those closest to them. It can also be a source of major tension.

The fact that a friends and family round is typically the first capital founders raise, means the “business” is likely little more than an idea, and maybe a business plan or a Powerpoint deck. In other words, it’s miles away from success and the road between here and riches is a veritable graveyard of failed ideas and burned investors. There’s a reason these rounds are often affectionately called, “friends, family, and fools" rounds.

Here are a few best practices to help ensure upcoming Thanksgivings won't involve catty talk from burned investors and awkward silences from family and former friends who've lost their money because of you:

1. Only raise money from people who can afford to lose it

The overwhelming majority of startups fail. While your startup may not be long for this world, your relationship with your friends and family should last much longer – if you don’t sabotage it.

Pension funds and other institutional investors typically allocate 5 percent of their capital to venture capital investing. Friends and family should follow similar guidelines and invest only a small portion of their liquid net worth. Ideally, they would follow a portfolio strategy and make several angel investments, but that may require more time and commitment than many non-professional investors are willing to dedicate.

The bottom line is don’t bankrupt your friends and family. Their support is presumably based on their love for and belief in you. Respect that and tread lightly when accepting their investment.

2. Set clear expectations

See point 1 above, things rarely work out as planned. As such, founders shouldn’t promise early investors 1,000 times return on their investment. Instead, founders should promise that they’ll do everything in their power to make this business a success, while also acknowledging that things could go very, very wrong.

Also, many friends and family investors lack the sophistication to understand the terms of a typical venture capital deal. Explain to these investors as clearly as possible what they’re signing up for. While the structure of the friends and family round may be simple, these investors will be affected by the terms of future funding rounds. Make sure friends and family understand the basics of concepts like dilution, liquidation preferences, and participation that could affect their ownership, or at minimum that their ownership will inevitably change over time.

3. Choose sophisticated and well-connected investors

If possible, take money only from sophisticated and well-connected friends and family – think lawyers, executives, or fellow entrepreneurs. Not only will these investors be more likely to understand the risks and mechanics of a venture investment, they may also offer valuable advice, introductions, or other resources that could benefit your business. At the same time, sophisticated investors are likely to ask the tough questions that a founder may loathe but will ultimately benefit their company in the long term.

By contrast, unsophisticated investors often require far more long-term handholding and reassurance than a founder can reasonably be expected to provide. To paraphrase a quote from the movie Boiler Room, “They're a constant pain in the ass and you're never going to hear the end of it alright? They're going to call you every fucking day wanting to know why [things aren’t going well] and God forbid the [company should take off], you're going to hear from them every fucking 15 minutes. It's just not worth it.”

4. KISS - Keep it simple (stupid)

When structuring a friends and family round, keep it as simple and straightforward as possible. Leave the complicated deal terms – like the above mentioned liquidation preferences and participation – to the VCs. Most friends and family rounds are structured either as a convertible note, aka a loan that converts into equity at a future date or milestone (like a subsequent financing event), or as common shares.

Union Square Ventures’ Fred Wilson suggest choosing the a convertible note, and giving investors a 25 percent discount to the valuation of subsequent funding round when converting into equity. Wilson also suggests capping that note such that friends and family investors own around 10 percent of the business if things go well and the next round is completed at a favorable valuation.

5. Be fair and respect the generosity of your investors

Raising money from friends and family may be the easiest money a company comes by. These investors are unlikely to conduct lengthy due diligence or negotiate aggressively on price or terms. Don’t take advantage of this. Not only is it unethical,  it could come back to cause problems during future funding rounds. Choosing a convertible note alleviates many of the downstream valuation issues but still requires founders to be thoughtful around conversion discounts and valuation caps.

6. Be mindful of legal issues

Just because these investors changed your diapers at one point in time doesn’t mean this investment is exempt from federal and state securities law. If a company is issuing stock, and in many cases when it’s offering convertible debt, these early investments must be either: (1) registered with the Securities and Exchange Commission; or (2) qualify under one of the applicable exemptions from registration.

For this and other reasons, consider consulting with a lawyer before completing a friends and family round. It doesn’t make sense to spend tens of thousands of dollars in legal fees on a round that is likely not much larger than that, but having an initial consultation (ideally with a friend of the family lawyer who won’t charge much, if anything) before going forward with the investment is always a good idea.

7. Taking money means taking responsibility

Accepting money from friends and family is serious business. It means making a commitment to seeing your startup idea through, even when the going gets tough. Silicon Valley culture has, in many ways, glorified the notion of failure and eroded the respect that many people have for the value of $10,000, $100,000, or $1 million. This is real money we’re talking about. Act accordingly.

As I referenced yesterday, holidays can be a difficult time for entrepreneurs. Whether it’s delivering bad news to friends and family, or simply struggling to step away and unplug from their ventures, the holidays bring founders an entirely different form of stress. Adding the dynamic of friends and family investors can surely exacerbate this fact.

Follow the above steps and you’ll set yourself up for the best possible outcome when accepting money from those you love.

Remember, whether they succeed or fail, most startups are short-term endeavors. Friends and family last a lifetime.

[Image via Crazy-Frankenstein]