Prior to doing a seed round or a full venture capital financing, startups frequently need to do a “friends and family” round of financing. This money is often essential to carry startups through to the point where an angel investor would be interested, especially in the regions where angels will require more than just an idea or even an MVP before investing. A poorly-handled friends and family round, however, can get a startup in a lot of trouble. It could result in penalties and fines for violating federal and state securities laws, and it could also jeopardize getting angel financing. This piece should give some guidance as to how to do a friends and family round the right way.
Before getting into the details, we need to cover some basic securities laws. I promise to keep it non-technical. The federal securities laws require that before a company can sell any securities, those securities either have to be registered with the SEC, or exempt from registration. The registration process is quite expensive, with public filings and extensive disclosures. Think publicly-traded companies, like Apple, or Google. To avoid the prohibitive expense of registering securities, startups and other private companies look to one of several exemptions. This is how seed rounds and venture capital financings are handled.
These exemptions allow companies to offer and sell to either accredited investors, non-accredited investors, or both. Without going into extensive detail, accredited investors are rich people who can afford to lose their entire investment, or people who are sophisticated enough so that they can understand the risks of investing in an unproven startup. Or both. The preferred route is to offer and sell securities only to accredited investors. This greatly reduces the paperwork and disclosures that would otherwise be required when selling to non-accredited investors, or the Great Unwashed, as I like to call them.
The problem with the friends and family round is twofold. First, there’s no “friends and family” exemption from the registration requirement. So the securities laws apply, and the friends and family round has to fit into one of the other exemptions. Meaning either the investors are accredited, or non-accredited. That leads to the second part of the problem. Most friends and family are non-accredited. It would be great if all our friends and family were wealthy, or highly sophisticated investors, but for most of us that simply isn’t the case. So how can we get financing from friends and family without getting in trouble?
OPTION 1 – Accredited Investors Only
This is the preferred route. Only offer the investment opportunity to accredited investors. You could use a convertible note, much as you would with your angel investors, or you could use the SAFE structure. SAFE is relatively new, and it means Simple Agreement for Future Equity. You can find a discussion of SAFE here. The general idea is to use fairly standardized documents that won’t require a great deal of customization. This will keep your legal costs down (but that doesn’t mean you should try this without a lawyer).
Some key deal points in this option, whether you use a convertible note or SAFE:
- Don’t include a valuation cap – trying to value the company at such an early stage just doesn’t make sense, and will most likely cause problems with later financing rounds.
- Do include a discount, to reward your investors for the risk they are incurring by investing at such an early stage. A 20% discount is fairly standard.
- Do include a “most-favored nation,” or MFN, provision. This allows the terms to be amended to be equivalent to the terms for the next financing round (typically the angel round).
- You might also consider having your MFN provide a discount to the valuation cap that the angel investors get in a seed round. After all, these early investors are taking on a higher risk than the angels, so they should be rewarded.
OPTION 2 – Non-Accredited Investors
So what about the situation where you need money, you have friends and family that want to invest, but none of them are accredited investors? First of all, if you allow them to invest, you are going to get into trouble with the securities laws, because in all likelihood, you won’t be able to comply with the disclosure requirements. So instead of letting them invest in your company, you should structure this as a loan.
This loan will be a straight loan, not a loan that converts into equity. You will need to make it clear to these people that if they get repaid at all, it will be their principal and interest. If your company gets bought by Google or has an IPO, they won’t become millionaires. Because this is a risky loan, the interest rate should be correspondingly high. The maturity date, which is when the loan becomes due, should be tied to a future funding event, rather than a date on the calendar. Also, set the threshold for this funding event high enough that it is not an angel investment; angels are putting money into your company to help it grow, not to pay back your early lenders. So the loan should mature at a funding event of several million dollars, which will likely be your Series A round. Finally, the loan should be subordinated to any future debt issued to angel investors. That means that the angel investors will get paid back before the friends & family.
Is this option a great deal for the friends & family? No, it isn’t, and there are a lot of risks for them, without much upside other than the satisfaction of helping you succeed. Remember, however, this option is your last resort. You turn to this when there are no accredited investors out there, and you need this money to stay afloat.
A final word about your legal expenses. It’s tempting to think that because the documents are fairly standardized, or because you are dealing with friends and family, you don’t need to use a lawyer. Of course you don’t want your legal expenses to be a significant percentage of the capital you are raising. Resist the temptation to think you can hack this, because you can’t. Somewhere along the line, you’ll make a mistake that will cost you a lot more later. A mistake could mean no angel round, or it could mean serious penalties imposed by the SEC. Even if you find the documents online – and the SAFE documents are – you still want an experienced lawyer to walk you through them, so you know what the terms are and how they affect you. Standardized does not equal simple. You’ll want to make sure you’ve covered all the bases, and the best way to ensure that is to use a professional.*
*The powers-that-be require me to say that this is an attorney advertisement, so just in case you weren’t sure already, this is an attorney advertisement.