A founder's friends and family are a common source of early capital -- but, be careful.
A founder’s friends and family are a common source of early capital — but, be careful.

We continue our Financing a Startup Company Series with the topic of raising money by issuing stock or promissory notes to friends and family.  Raising money from friends and family is often one of the easiest sources of funding for entrepreneurs to tap.  Many startup companies, including Apple Inc. in its early days, turn to friends and family to raise their first round of funding.  Friends and family are also often willing to invest without receiving much control over the company’s operation and they will not demand the same high rate of return that more sophisticated investors will insist upon.

What types of investments do friends and family make?  Friends and family investors can take equity in a company, however, as discussed in the post on Bootstrapping, to avoid adverse tax consequences, it is usually advisable to issue convertible debt.  A further advantage of using convertible debt with friends and family is that you postpone the tricky decision about how much equity they will receive for their investment until a later date.  Offering the friend or family member a discount of around 20% on the next round of financing is standard.

How much will friends and family invest?  While the amount that can be raised from friends and family ranges widely depending on who your friends and family are, in the aggregate, the average amount invested by friends and family is in the 20-25K range.

Is there a securities law exemption for friends and family?  A very important note is that, contrary to popular belief, there is NO “friends and family” exemption to the Federal securities laws.  When issuing stock to anyone, a company must comply with one of the exemptions from the registration requirements.  For more information, check out our earlier post on the perils of non-accredited investors.  

What are the costs and potential disadvantages to accepting investments from friends and family?  There are many ways that mixing personal relationships with business can lead to problems with both.  Founders must be careful to manage the expectations of friends and family.  Inexperienced investors, such as friends and family, must be made aware that they are likely to lose their entire investment.  Even if the company doesn’t fail, founders need to be very careful about managing the expectations of their inexperienced investors when discussing valuation, risk, exit strategy, and the duration and illiquidity of the investment.  As an aside, many VCs will not invest in companies that have friends and family investors.  Founders considering investments from friends and family should consider the potential downstream consequences of accepting money from early investors who later, more sophisticated investors may deem as “too risky.”