One of the most prevalent sources of early-stage capital is also one of the most risky.
As the investment climate is making it especially difficult to raise seed capital, in this week’s edition, we outline some best practices and strategies for raising what have become known as “friends and family” rounds. While enabling your immediate circle of friends and family to get a stake in your startup can be a great opportunity and alternative to pre-seed funding, it does come with some caveats one needs to be aware of.
Pitching to Family and Friends Pitching to family and friends can be a daunting task. On a surface level, the traditional goal of pitching still applies — selling the proposition and upside of your startup to a potential investor. Yet, family and friends, most often will neither commit to doing independent and in-depth risk analysis, nor balance out their portfolio with multiple bets as traditional investors do. Thus, in these pitches, the downside potential and the fact that more than 80% of startups fail has to be pronounced. Angel investing, after all, is somewhat like purchasing very expensive lottery tickets. On a similar note, founders should under no circumstances raise sums from individuals that would be significantly financially hurt if they lost their entire bet.
Only raise sums from friends and family that are financially able to potentially lose their entire bet, and aware of the likelihood that they will.
Deal Structure: If possible, the preferable structure of a friends and family round is a SAFE note. SAFE stands for Simple Agreement for Future Equity. Its main benefit is that it essentially allows entrepreneurs to skip the conversation regarding valuation at the early stage. It delays declaring an equity stake for the investment, by using the valuation of the next priced round. So for a simplified example, if you receive an investment of $100K and your next round is at a valuation of $5M, the investor will receive 2% of the company. Look for a future post discussing SAFEs in more detail. Also, make sure you use proper legal documentation or a lawyer, and use standard venture terms as if an outside angel investor was investing. Stay away from any preferential terms, however, as these deter future professional investors. The Accredited Investor Issue: Formally, founders trying to raise in the US, are going to face the added complexity of ensuring that the friends or family members they take money qualify for Accredited Investor status. There are some nuances in what constitutes an Accredited Investor set by the SEC, but in short, it’s an individual with at least $1M in net worth or $200K in annual income. Legally, only accredited investors are permitted to make high-risk investments, in this case, angel investments. There are ways to circumvent the requirement for Accredited Investor status, but in general, we recommend against those methods.
Being able to raise a friends and family round is reserved for those in financially privileged circles. After all, you need to have friends or family members wealthy enough to make such investments. For the many of us that are not able to do so, potentially more equitable alternatives include crowdfunding, accelerators, and early-stage VCs. Stay tuned on our blog for posts discussing these topics in the future.
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