Introduction

 So you’ve gotten the idea for your new startup solidified and have determined what entity best fits the needs of your business plan and goals. Now comes the question of funding. How do you secure financing to get your product or service to market?

While many startups receive their funding through angel investors and venture capitalists, “over one third of startup founders have raised money from friends and family.”[1] Friends and family funding accounts for almost 60 billion dollars.[2] While raising money from family and friends certainly has its advantages, there are a few legal implications to be aware of before adding your best friend or sister to your list of potential investors.

Let’s start with the obvious (i.e., advantages). First, friends and family are often more willing to invest in you without seeing a firmly established company or without a preference of a Delaware C-Corp like many venture funds typically require. Second, there might be reduced transaction costs and legal fees associated with these investors because of minimal due diligence and simple documentation. Lastly, these investors may be more forgiving if your business is off to a rough start.[3] In spite of these advantages, there are some important roadblocks that could cause issues for your startup.

Securities Law

Under federal securities law, there are many rules and regulations that determine limits on the amount of money raised, how you ask for investments and even the number of investors you can have. In addition to this, many states have their own “‘blue sky laws’ which are an individual state’s laws that generally regulate the number of accredited investors, the level of ‘sophistication’ of investors, and the information that needs to be provided.”[4]

Under Section 5(c) of the Securities Act of 1933 (‘33 Act), any securities offered or sold in interstate commerce need to be registered unless exempted from registration by some other provision. One such exemption is Section 3(a)(11) of the ‘33 Act; it provides an exemption for “any security which is a part of an issue offered and sold only to persons resident within a single State or Territory” where the issuer is a resident of that state or territory. In this case, the “blue sky laws” of your state would apply. But you should be careful as one interstate investor/purchaser can destroy the exemption. In addition, the Securities and Exchange Commission (SEC) may “integrate” multiple offerings, meaning if offerings are too similar and too close together in time, they will be considered the same offering. In other words, this may add a different state investor to your mix and cost you the exemption.[5]

The most common federal exemption is the private offering exemption, Section 4(a)(2) of the ‘33 Act. Specifically, Section 4(a)(2) provides an exemption “from registration offers and sales by the issuer that do not involve a public offering or distribution.”[6] While this may seem like a simple greenlight to have family and friends invest, fitting neatly under 4(a)(2) can be particularly difficult. To assist, the SEC promulgated safe harbor rules for private offerings in the form of “Regulation D” (Rule 504 and Rule 506). Regulation D Rule 504, provides an exemption from registration requirements for companies selling securities under the $5 million limit. The SEC will typically further limit the purchasers of these securities from selling the securities for at least six months or a year without registering.[7] Regulation D Rule 506(b), the most commonly used rule under Regulation D, allows for an unlimited amount securities to be sold to any number of accredited investors but only 35 non-accredited investors who alone or together with their purchase representatives must be sophisticated investors.[8] What does this mean for you?

You should make sure that your friend or family member is either an accredited investor or a sophisticated investor before they can invest in your startup. The definition of an accredited investor is relatively extensive but Rule 501(a) gives 8 categories of investors that ranges from institutional investors to individuals with a net worth of $1 million alone or jointly with a spouse.[9] A sophisticated investor on the other hand, is an investor who has “sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment.”[10] If your friend or family falls into the category of a sophisticated investor, Rule 502(b) states that they must be given extensive and comprehensive disclosure information that would typically be required for an initial public offering registered with the SEC, which often takes the form of private placement memorandum.[11] This could include, “the most recent balance sheet, income statements, statements of stockholders’ equity” among other things.[12] The extensive disclosure required under Rule 502(b) can be costly thus it is important to consider whether including your family and friend investors who fall into this category is a viable option for your startup.

Violations of securities law can lead to heavy sanctions such as fines, criminal penalties, and prohibition from using further securities exemptions; so it is best to read more about accredited investors and blue sky laws in your state to make sure you are in compliance.

Damaged Relationships

Not to overstate the obvious but having friends and family as investors can potentially cause a strain on your relationships. If you run into business problems that impact how and when you can pay back your investors, this may cause bad feelings to arise between you and your friends and family investors. The best way to avoid these types of issues is to spell out your mutual expectations in the beginning. In the case that you have given them a debt instrument you may even want to include a promissory note between you and your investor.

Valuation and Structuring

Often times, friends and family investors are willing to accept equity shares at a valuation an unrelated investor would never accept. This has the potential to make it difficult for an unrelated investor to come in a later funding round and get a fair share and fair value for their investment.[13] To avoid this, you should bring in investors, including friends and family, at a fair value from day one.

Helicopter Investors

Sometimes friend and family investors who are not very experienced may be more inclined to be hands on with the business. It is definitely important to keep them informed of what is going on with the business but in no way should they be making business decisions. The best way to circumvent this problem is to create shareholders agreements that delineate voting rights and board representation. Typically, only those friend and family investors with particular expertise or experience helpful to your business will be given greater involvement in the business.[14]

Conclusion

The sections above give a quick overview of some of the pitfalls that can come with friends and family investors in your startup. It is important to be mindful that these sections are not exhaustive and that you should spend time researching how having someone connected to you personally can impact your startup or even consult an attorney to go through these issues more deeply as it relates to the specifics of your business.

Below are a few resources that give more background to friends and family investors:

  1. Friends and Family Round v. Angel Round (DLA Piper): https://www.dlapiperaccelerate.com/knowledge/2018/friends-and-family-round-vs-angel-round.html
  2. The Ins and Outs of Raising Money from Friends and Family (Entrepreneur): https://www.entrepreneur.com/article/228103
  3. Accredited Investors: Everything You Need to Know (Upcounsel): https://www.upcounsel.com/accredited-investor
  4. Startup Funding Infographic (DLA Piper): https://assets.entrepreneur.com/article/where-startup-funding-really-comes-from-infographic.jpg?_ga=2.16960633.1501778517.1514518759-1713169306.1514518759
  5. SEC Rule 504: https://www.sec.gov/fast-answers/answers-rule504.html
  6. SEC Rule 506: https://www.sec.gov/fast-answers/answers-rule506htm.html

 

 

 

[1] https://www.upcounsel.com/friends-and-family-investors

[2] https://www.upcounsel.com/friends-and-family-investors

[3] https://www.entrepreneur.com/article/228103

[4] https://www.upcounsel.com/friends-and-family-investors

[5] See generally, http://securities-law-blog.com/2009/11/06/securities-law-update-intrastate-offerings-section-3a11-and-rule-147-examined/

[6]Section 4(a)(2) and Regulation D Private Placements, Practical Law Practice Note 8-382-6259.

[7] See, https://www.sec.gov/divisions/corpfin/guidance/rule504-issuer-small-entity-compliance.html

[8]Section 4(a)(2) and Regulation D Private Placements, Practical Law Practice Note 8-382-6259.

[9]Section 4(a)(2) and Regulation D Private Placements, Practical Law Practice Note 8-382-6259.

[10] https://www.sec.gov/fast-answers/answers-rule506htm.html

[11] https://www.varnumlaw.com/newsroom-publications-reasons-to-include-only-accredited-investors-in-your-rule-506b-private-offering

[12] https://www.varnumlaw.com/newsroom-publications-reasons-to-include-only-accredited-investors-in-your-rule-506b-private-offering

[13] https://www.upcounsel.com/friends-and-family-investors

[14] https://www.upcounsel.com/friends-and-family-investors