The Friends & Family Round

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.

Anatomy of a Term Sheet 2 – Pre-Money Valuation and the Option Pool

Welcome to Anatomy of a Term Sheet Part Two.

In the first part, we looked at the introductory language and some of the basic offering terms in the model term sheet of the National Venture Capital Association, which you can find here.

Today we are going to look at two remaining basic offering terms – price per share, and pre-money valuation. The pre-money valuation term raises a very important issue for founders, involving the employee option pool and the dilutive effect this term will have. So join me as we dig in… 

The first term to examine in this part is:

Price Per Share: $[________] per share (based on the capitalization of the Company set forth below) (the “Original Purchase Price”).

This is the price that the VC investors will be paying for each share of preferred stock. If there are angel investors who put in money through a convertible note, they will probably be paying a lower price per share when converting the loan to equity, due to price discount and valuation cap terms in the convertible note financing.

The next term, which is a crucial one to understand, involves pre-money valuation and the employee option pool:

The Original Purchase Price is based upon a fully-diluted pre-money valuation of $[_____] and a fully‑diluted post-money valuation of $[______] (including an employee pool representing [__]% of the fully‑diluted post-money capitalization). 

The pre-money valuation is the valuation immediately prior to the VC investment, and the post-money valuation is the pre-money valuation plus the amount of the investment. So, if the pre-money valuation is $4 million, and the VC is investing $2 million, the post-money valuation is $6 million.

Note the use of the term “fully-diluted” in connection with the pre-money valuation, post-money valuation, and post-money capitalization. “Fully-diluted” means the highest potential amount of common stock that could be outstanding, regardless of vesting and assuming that all options and other securities (such as convertible notes) are converted into common stock.

The inclusion of the employee option pool in the post-money valuation and capitalization has the effect of diluting the founders’ share of the startup, without diluting the VC investors’ share. To see how this works, let’s return to the scenario just described, where the pre-money valuation is $4 million, the VC investment is $2 million, and the post-money valuation is therefore $6 million.

Assume there are two founders, each with 50% of the stock pre-money, and there is no option pool. Thus, prior to the VC investment, the founders owned 100% of the company, collectively. After the investment, if there is still no option pool, the VC fund will own 33% ($2 million divided by $6 million) and the founders’ stake will be reduced to 66%.

As a practical matter, however, the VC will require the startup to set up an employee stock option plan and set aside an option pool for the employees. Startup companies are typically short of cash, and the stock option plan is an important tool for attracting and retaining talented employees, and giving them an opportunity to share in the increasing valuation of the startup.

When the VC uses the above language to require an option pool, it is taking that option pool out of the founders’ share, further diluting the founders, but not diluting the VC. To determine the price per share, the post-money valuation is divided by the fully-diluted number of shares outstanding, plus all the shares or options that will be issued in the future as part of the option pool.

Let’s take a second look, assuming the option pool is 20% of the fully-diluted post-money capitalization (20% is a fairly common size for option pools). Now the cofounders only own 46% of the post-money company (66% minus 20%), while the VC investor still owns 33%. The founders’ share of the company has been diluted, but the VC’s share has not. The founders’ ownership has decreased by 30%, all due to that “post-money capitalization” language.

What can the founders do to avoid or mitigate the dilution that is caused by the option pool? As a practical matter, a startup will not be able to have the VC’s remove the option pool requirement, and that isn’t a good idea anyway. As I mentioned before, stock options are an important tool for attracting and retaining good employees, especially when the company is cash-poor. Stock options are desirable, it’s the dilution of the founders that is problematic. Unfortunately, founders also will not be able to get the VC’s to share in the dilution alongside the founders. The VC’s have the upper hand here, because they have the money. There are a few partial remedies that are possible.

The first remedy is to negotiate for a higher pre-money valuation, to compensate at least in part for the option pool dilution. Going back to the previous example, let’s suppose the pre-money is $5 million, with the VC’s investing $2 million. The post-money is now $7 million. The VC’s share of the post-money capitalization is 29%. The founders’ share is now 51% (taking into account the 20% option pool), which is better than the 46% share when the pre-money was $4 million.

A second remedy is to try to reduce the size of the option pool as much as possible. If your startup already has an executive team in place, you might be able to get away with a 10% option pool; you don’t need the extra options to entice a CEO or other top executives.

A third remedy is to already have the option plan and pool in place before going to the VC investors. Whether this is possible will depend on where the startup is in its development process, as well as the finances of the startup. Setting up a stock option plan will cost about $1500 to $2000 (maybe more, maybe less), and if the startup has money available from an angel investment, it may be a good use of funds. The stock option plan will make it easier for the startup to attract employees at this stage, allowing it to stretch its funds a bit further. And if the plan is already in place, the VC’s may not push as hard on the size of the option pool.

Hopefully this helps to explain a fairly complex yet common issue that arises when negotiating with VC investors. Next time, I will write about the alternative provisions for dividends.

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