The Biggest Risks of Raising Money from “Friends and Family”

16 mins read

When you’re starting a business, there are many ways to raise money. One of the most common is to get investments from friends and family. This can be a great way to get started, but it also comes with some risks. In this blog post, we will discuss the biggest risks of raising money from friends and family, and how to minimize them.

More than one-third of business entrepreneurs have obtained capital from friends and family. In reality, these investors provide more than $60 billion annually to companies. That exceeds the total amount of angel investors and venture capitalists.

 

Fundraising from friends and family offers several benefits. They are often more eager to invest in you as an individual, while a bigger investor may want a more established company. You may also be able to circumvent the stringent regulatory procedures that accompany the selling of other securities. Other advantages may include a more direct line of communication and longer investment horizons.

 

However, there are a number of precautions you should take before accepting money from friends and family, such as:

 

The upside is not as great as they believe.

The first investors in a business are likely to experience significant dilution prior to exit. Inexperienced investors will likely not comprehend what this implies, and if the firm is successful, they will be in for a rude awakening. Suppose, for instance, that friends and family are willing to invest $10,000 in return for 10% ownership of the company. They will anticipate that they will get $1 million if the company sells for $10 million dollars. Not bad, yes? By the time the company is actually sold, however, factors such as dilution and alternative distributions (e.g., shares of the acquiring company rather than cash) will bring the actual value closer to $100,000. After accounting for taxes, your first investors will not get more than a few tens of thousands dollars apiece. It’s not terrible money, and it’s a wonderful return on investment, but it’s obviously not enough for them to retire. Oh, and this is all based on the assumption that the professional investors will not completely force out the friends and family, in which case they will get nothing. This occurs more often than most would want to acknowledge.

 

They invest because they are as ignorant as the businesses’ founders about what it will take for the startups to thrive. Consequently, investments from friends and family can mislead entrepreneurs into feeling they are creating something valuable that the market does not really want.

 

To see why this is problematic, let’s compare it to collecting funds from expert investors. Professional investors don’t always make the correct investments, but they see so many startups that their ability to assess a company’s success potential is significantly superior than that of the vast majority of individuals (including your friends and family). Consequently, and regardless of whether entrepreneurs are willing to recognize it, experienced investors are a useful source of feedback.

 

When investors choose not to invest in you, they are not deliberately hurting your feelings. Actually, they are doing you, the entrepreneur, a tremendous service. They assist you in determining whether or not your company has found a feasible market opportunity. In contrast, neither friends nor family do this. They really do the reverse. They invest because they care about you and have faith in your success potential. This may make you feel better about yourself, but it is also likely to lead you to believe your startup is superior to what it really is. This will negatively impact the company’s long-term prospects for success.

 

One of the primary disadvantages of combining money and business is the possibility of losing both. Indeed, connections are more important than money. Sadly, it has become a source of discord and disagreement between friends and family. If your firm is not generating earnings or if a family member or close friend is not receiving the anticipated benefit, it may lead to disagreements and ultimately destroy relationships.

 

 

They are unaware of the risks

Investing in startups is a high-risk endeavor. Professional investors recognize this danger, which enables them to psychologically prepare for investment investments. Your family and friends will not be as prepared. Yes, they will tell you they are, and they won’t make a huge fuss if you lose their money. However, they will always regret it and harbor some type of resentment.

 

Because investing in startups is so hazardous, professional investors use a portfolio strategy that allows them to manage risk across several firms. However, your friends and family often lack this choice. They probably have less capital to invest, and they are unlikely to invest in several firms. This implies that any money they invest in your firm will represent a considerably larger portion of their entire wealth than it would for a regular, professional investor; as a consequence, they will be forced to assume substantially more risk than professional investors.

 

Never enable eager friends or family members to invest their life savings or deplete their retirement account. This kind of risk places excessive pressure on you to return their investment. Accept just what they can afford to lose, regardless of your degree of assurance.

 

Also, keep in mind that our richest acquaintances and relatives may not necessarily be the finest investors. A smaller investor with the knowledge or contacts you need to expand may be of much greater assistance.

 

At this stage, it is crucial to be completely honest with yourself and your family/friends: statistically speaking, it is most probable that your business will not provide a return for investors. In reality, the probability of a return of zero is the greatest.

 

Experienced startup investors are aware of these odds, which is why they construct a diversified portfolio with the expectation that the majority of their investments would fail. However, your friends and family may not have this plan in mind when they invest in your firm, so you need consider the relationship dynamics during the next Thanksgiving meal. Ideally, you should have a clear communication with them beforehand in which they say something like, “Yes, I am aware that I will likely lose all of this money, but I am prepared to take that risk on you and your business.”

 

Moreover, the illiquidity of the investment is an additional concern that must be addressed with novice investors in startups. Even if there is a return, it may not occur for 7 to 15 years or more (this should be the mental expectation of your investors). In the interim, selling the stock is not nearly as simple as it is when dealing with publicly traded equities; ensure that investors realize this.

 

An accurate valuation is very difficult.

It is hard to appropriately balance the risk potential of a startup with a suitable ownership position at the friends and family stage of investment. Simply said, your friends and family are taking a substantial risk and, as a consequence, they deserve hefty compensation in terms of equity/ownership. However, adequately paying them (20%-40% stock given the magnitude of the risk) would cripple the company’s future ownership structure and make it difficult, if not impossible, to obtain more financing.

 

Frequently, early-stage firms offer huge equity shares to family and friends at valuations that an unconnected investor would never accept (e.g., selling stock for $1 per share with 10,000,000 shares outstanding, valuing the company at $10,000,000). This makes it impossible for an angel investor to invest in a subsequent financing round at a fair price and fair share.

 

If this occurs, you should reorganize your company and reallocate stock among friends and family such that everyone ends up with the amount of shares they would have had if they had invested at a fair price. In addition to negative emotions, overvaluation might lead in very expensive legal and financial implications.

 

To prevent this issue, you should acquire all investors at a fair price from day one. Since the pre-money valuation for angel investors is often between $1 and $3 million, the pre-money valuation from friends and family should be between $250,000 and $1 million. The average amount raised from friends and family is between $25,000 and $150,000.

 

Lack of understanding of the securities laws

Investments made by friends and family are not exempt from securities law. They just virtually always qualify for an exception. Before requesting investments, acquaint yourself with any restrictions imposed by securities law, including restrictions on the amount of money obtained, the number of investors, and the manner in which you request investments. You may also be required to comply with “blue sky laws,” which are state-specific regulations governing the number of unaccredited investors, the amount of “sophistication,” and the information that must be presented.

 

Even accidental violations of securities rules may lead in punishments, such as hefty fines. You may read more about raising capital from accredited investors and the JOBS Act for additional information.

Two basic guidelines to keep in mind are:

 

In order for your investors to make an educated investment choice, you must offer them with complete transparency via a prospectus or other ways.

 

You are required to register with the SEC unless you meet the conditions of a specified exemption.

 

 

Interference

Friends and family who are not seasoned investors may need continuous updates or expect to participate in company decisions. While keeping them informed is beneficial, they should not interfere with your everyday operations. Under no circumstances can business choices be made under peer pressure.

 

Create a shareholder agreement outlining voting rights and board membership. Allow a larger level of participation only if the investor has particular skills or expertise that you respect.

 

 

Not having your own skin in the game

Often, other investors and lenders (including your family and friends) like to see that you have invested your own money. This raises your motivation to preserve your own investment by avoiding excessive risks and cutting wasteful expenditure.

 

When investment becomes more personal, this becomes even more vital. If you share in a possible loss, your friends and family will feel less deceived if a portion of their investment is lost.

 

 

 

A Lackluster Business Plan

Even when working with friends and family, do not make the mistake of having a poor business strategy. One of the disadvantages of having people invest in you as opposed to your company is that they may not be as critical of your business strategy. While this may seem to be less work for you, it is really a negative development.

As in circumstances when you are totally self-financing, a solid business strategy serves as your road map for the future, guaranteeing that you have considered potential obstacles.

 

Be very specific about what results you intend to achieve with the money. While it’s not required to have a pitch deck, executive summary, and financial model to share with friends and family at this time, the more you have in place, the better. When seen from the standpoint of an investor, they should know precisely what they are getting themselves into and wager on the asset’s future market value in order to make a return.

 

As you raise subsequent rounds of funding, you’ll need to develop the habit of providing investors with updated paperwork, but for now, you should concentrate on developing a detailed strategy for your product, marketing, sales, and team expansion goals.

 

Too much confidence

It’s admirable to be eager and even self-assured, but you should never overpromise. Your friends and family investors must be completely aware of the risks, including the fact that 90% of businesses fail.

 

In addition to regulating expectations and safeguarding relationships, this may also provide legal protection.

 

Although uncommon, a failed investment might lead in claims of breach of contract or even fraud. Including the risks in a formal prospectus can provide you with further protection if you are ever sued.

 

 

Broken relationships

If your firm is unsuccessful and you are unable to return investors’ funds, negative sentiments may develop. If you give yourself a salary or do not utilize personal financial windfalls to repay investors, the danger is significantly bigger.

 

Even if you and your investor are happy with an informal agreement, it is essential to outline your respective expectations. Consider it similar to a prenuptial agreement before marriage. If you anticipate for the potential that something could go wrong, it is less likely that minor company losses would result in large personal losses.

 

You may also choose to establish repayment conditions using a promissory note that specifies the amount of time and interest rate required to get the money back. Consider employing a convertible note if they are interested in equity, as stated before.

 

 

 

 

Tips for successful Friends and Family round

 

Here are some tips to address the aforementioned risks.

– Determine the amount required

It’s tempting to aim for the stars when you’re on top of the world and just starting to construct your dream company, but one of the functions of a Friends and Family round is to serve as a springboard. Instead of predicting the highest amount of funds you can get, you should plan strategically and rationally. Create a four- to six-month plan and establish how much cash will be required to purchase all necessary merchandise and assets, in addition to any funding required for early-stage personnel. By being extremely rational with your first request, you will be in a better position to seek extra funds in a few months if the firm is still doing according to plan.

 

– Draft a business plan

Friends and Family investors often invest more in you and your enthusiasm than in the company itself. However, this does not imply you should walk in with nothing more than an idea on a napkin; you must have at least sound principles and well stated objectives. You do not need a professionally-designed PowerPoint or a high-budget presentation, but it is excellent if you can express your plans for the first six to twelve months. Include how you intend to use the initial cash, the equity choices that may be available, and the inherent risks. Despite the fact that you can’t definitively quantify the worth of your concept or company, comparing what you’re doing to that of rivals or comparable markets may be effective in persuading early investors to write you a check.

 

– Educate yourself on available methods

In a Friends and Family round, there are several methods in which folks close to you might contribute to the launch of your firm. Below are the three most frequent methods that an investor would invest in such an early funding round, as well as the amount of legal help you should consider: – Loans: A scheduled repayment or repayment with interest. Numerous experts recommend loans as the optimum method for friends and family to invest due to the fixed repayment periods. They will know how long it will take to receive their money back and how much interest will be charged. (If you are current on your payments, you can also escape their ire by spending money on yourself.) A company attorney can quickly draft a promissory note outlining the loan’s conditions. A SBA Community entry provides an alternative approach to formalize the relationship: structuring the loan via a peer-to-peer (P2P) lending company that would function as a middleman and collect the payments from you for a fee.

The disadvantage of borrowing is that the repayments consume a portion of your company’s cash flow.
– Equity: Investors become business partners and are entangled with the enterprise. You don’t have to pay them until you earn a profit or cash out, but if you offer a friend or family an ownership position in your company, you are essentially making them a business partner. You should contact a business attorney for this. Consider if you want this individual as a business partner. He or she will have the authority to instruct you on how to operate the venture. If your acquaintance/investor has entrepreneurial experience or other valuable knowledge, this may be quite advantageous. However, it may rapidly become annoying if ignored. You also run the danger of hurting the connection if you leave to pursue another venture.
– Gifts: You do not have to repay the money.
In principle, gifts are the easiest kind of investment. Someone presents you with money, and the narrative ends there. They have faith in you and your goals and want your success. However, you should never underestimate human nature, and as a result, you still need to make a written agreement to ensure that both sides are fully aware that the gift-giver will get nothing if the company is successful. Specifically, someone may subsequently argue that the gift was really a loan and that they are now entitled to a share of the profits. Similar to gifts, loans are quite simple in the Friends and Family round. It is still preferable to have a legal organization assess the loan conditions or to utilize a peer-to-peer lending business that works as a loan. Either interest on the loan or dollar-for-dollar repayment will be required by the money-lender. The agreement must next specify how and when the money must be returned, any conditions, and the related risk. By having an agreement in place, you formalize the professional aspect of your connection with the investor while keeping the personal aspect. Since a result, there should be no stresses or friends pursuing you for loan repayments, as both parties have already agreed to the conditions. At the Friends and Family level, equity investments might be somewhat more difficult. Therefore, it is highly recommended that you consult an attorney so that a written agreement can be created. If you want to pursue formal investors in subsequent rounds, it’s also crucial not to dilute the number of shares available. In addition to the monetary investment, these individuals will become shareholders in your company, which comes with a number of restrictions that we shall discuss later. When someone is interested in becoming an investor and wishes to obtain equity in return, a convertible note or convertible equity is often recommended. If your friends and family want to invest in exchange for equity, it is your job to outline the associated risks. Startups are dangerous ventures, and as a founder, you run the risk of hurting your connections if your early-stage investors are not properly informed; as the founder, it will likely fall on your shoulders to deliver this straightforward introduction level investor education. The safe templates provided by Y-Combinator are a well known agreement for precisely these sorts of investments.

– Create Term Sheets and repayment strategies

If you are securing a loan, with or without interest, you must design a repayment plan that is acceptable to both sides. By doing so, you lessen the danger to your personal connections, as everyone will be aware of and agree to the repayment date. A repayment strategy also prepares you for milestone loans. A single individual invests an initial amount, and if the firm reaches a certain milestone (or surpasses it), the lending party deposits another predetermined amount of funding. This is also a typical strategy among investors in later stages. Regarding the creation of term sheets, you will certainly need the assistance of a startup attorney, since this is a highly individualized legal area. Developing term sheets, not just for investors but also for your workers and cofounders, is required for future fundraising. This helps to prevent excessive dilution of equity. The term sheet will also include a description of the risks involved, in the event that your investor(s) do not get a return on their investment.

– Focus on the right individuals

Receiving a gift or a loan is straightforward, and you can nearly approach anybody you trust and who has adequate finances for assistance. When it comes to equity or convertible notes, however, more consideration is required. Similar to selecting investors who will contribute value in bigger rounds, you should examine whether these friends and family investors have a professional experience and who really understands the risks and rewards of funding your project. The Small Business Administration provides solid guidance on this subject. Don’t resort to your father or closest friend just because they are who you know. Choose a candidate with good business abilities who is aware of the risks and advantages of the venture. Remember that if your firm fails and you cannot return your debts, your relationships will suffer. At a minimum, limit your list to friends and family who have trust in your success, who comprehend your plans, and who are aware of the risks.

– Introduce them gently

Once you have determined who to ask, introduce them gradually. Do not send random messages to your college or high school friends announcing your plans to earn millions and inviting them to join you. Investing is as much about creating relationships as it is about selling your company concept on its own merits. Asking for their advice on your proposal and providing them with updates on the business’s progress are two strategies to win over a possible investor. Your investors will likely be more receptive to your pre-seed fundraising pitch if you have already demonstrated your ability to communicate clearly, demonstrate early traction, and be receptive to their advice. As a result, they will place more value on you as an individual founder and be more willing to consider your pre-seed fundraising pitch.

– Present the pitch

When appropriate, make your pitch. In certain instances, investors may inquire directly how they can participate, which will simplify the procedure. Regardless of who makes the first move, concentrate on ownership shares, complementary services or goods, future discounts, and other incentives you might give to assist get the sale closer to completion. But most importantly, explain clearly about your goal, how you will get there, and what you can assess at each step to demonstrate success.

– Don’t over-dilute equity

If there is one major limitation to attracting investors via early equity shares, it is the need to arrange for an equity cap. Since a result, subsequent investment rounds will be simpler to get, as the equity will not be diluted early on. Equity may be a significant motivator for early-stage personnel, as well to future investments. Therefore, it is essential to be cognizant of this feature while recruiting early passive stakeholders.

 

– Create paper trail

Record everything. It’s that simple. Startups often put regulations and formalities on the back burner, which may lead to a much larger disaster in the future. If you have your finances and contracts in order, future investments will go much more smoothly.

– Keep investors updated

Remember that one of the most important aspects of a Friends and Family round is that these are individuals with whom you already have a close connection. Due to the fact that these investors are invested in your success, it is a good idea to keep them informed and up-to-date on how things are moving. This is particularly vital for people who may own equity shares. Make sure it doesn’t become a time-consuming distraction, but once a month is a reasonable frequency to start early on when establishing open and continuing contact with your investors.

 

Other methods of fundraising

If you are undecided about whether you want to seek money from friends and family, you may choose to contact institutional investors such as angel investors and venture capitalists.

If you want to accept investments, it is prudent to retain legal counsel to avoid potential pitfalls. Even if you believe you’ve done all the necessary research, securities laws and investment contracts are complex enough so that there is a substantial possibility you’ll overlook something that would be clear to an experienced attorney.

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