Funding is one of the biggest hurdles that many startups face. For some companies, fundraising has to happen early on, before the startup even introduces a viable product in the market. For these founders, that can often mean taking out loans, bootstrapping from personal savings—or sometimes, it means finding investors who believe in their vision from the very early days. Unfortunately, even more challenging at an early stage to convince traditional investors to join to an initial funding round. For that reason, startups seek funding at the earliest stages instead tap into their existing relationships – this stage of fundraising is often called the Friends and Family round.
A Friends and Family round typically results in anywhere from $10,000 to $150,000 in funding that allows a startup to get through its first few months of operation. This round is sometimes labeled as pre-seed round, or even a bridge round, but the result is usually bringing on initial employees, securing office space, and/or purchasing other key resources needed to become operational. The Friends and Family round differs from angel rounds in that, as the name states, the funding comes from your friends, family, and connections, instead of from an accredited investor.
There are pros and cons to fueling your startup with money from the people around you, which is why it is critical to approach the right people and to keep the process highly professional in nature. This can certainly be a challenge when it comes to seeking out money from those you are close with, but projecting an aura of professionalism is a necessary component for any level of fundraising.
For starters, consider the valuation of your company.
1. Valuation, Sort-of
It is typically very difficult at this stage to place any kind of realistic valuation on your company. At a pre-seed level, excluding the bootstrapped companies that have been around for a while, these Friends and Family round startups will have little to no revenue prior, and maybe some LOIs from prospective customers. Because of the lack of revenue, it is very difficult to project into the future and accurately depict what the next few years will look like, and even harder in turn to provide a realistic valuation of the company.
That said, there are agencies such as Gust that will provide companies with a pre-seed valuation. With this kind of third-party backing, the approach can provide some added legitimacy to the numbers, rather than just slapping on your own self-declared valuation—but any pre-revenue valuation will still considered questionable. Luckily, friends and family often won’t care nearly as much about projected valuations versus the typical accredited investors who really knows the ins and outs of private equity with a more stringent and objective valuation criteria.
2. Understand the Types of Investing and Funding
In a Friends and Family round there are several ways that those around you can contribute to getting your startup operational. Below are the three most common ways that someone will invest in such an early round, and the level of legal support that you should consider:
- Loans: A planned repayment or repayment with interest (*Use a peer-to-peer lender or an agreement template)
- Gifts: You don’t have to pay back the money (*Always put a formal agreement in place)
- Equity: Investors become a business partner and are intertwined with the company (*Advised to check with a lawyer, and definitely sign a formal agreement)
Gifts are in theory the simplest form of investment. Someone provides you money, and that is the end of the story. They believe in you and your vision and want to see you succeed. However, you should never underestimate human nature, and because of this, you still need to produce a formal agreement so that both parties fully understand there will be no outcome for the gift-giver in the event that the business becomes successful. More specifically, someone could come back later on and claim that the gift was actually a loan, and that they now want a piece of the pie.
Like gifts, loans are relatively straightforward in a Friends and Family round. It’s still ideal to get a legal entity to review the terms of the loan, or else use a peer-to-peer lending service that functions like a loan. Either the money-granting party will seek interest on the loan, or dollar-for-dollar repayment. From there, the agreement needs to state how and when that money needs to be repaid, any stipulations, and the associated risk. By having an agreement in place, you formalize the professional component of the relationship, while preserving your personal relationship with the investor. In turn, there should be no stressors, or any friends chasing you down for loan repayments, because both parties have agreed to terms beforehand.
Equity investments at the Friends and Family stage can be a bit more complicated. Because of this, it’s strongly advised that you involve a lawyer, so that a formal agreement can be drafted. It’s also important not to dilute the number of shares available, if you plan on seeking formal investors in future rounds. Beyond the dollars, these people will become a part of your business as shareholders, which comes with several stipulations—but we’ll tackle those later on. It’s typically advised to use a convertible note or convertible equity in these cases, when someone is interested in becoming an investor and wants to receive equity in exchange.
As mentioned previously, a startup at this stage typically has close to zero revenue and is still a seed in the ground. That means your valuation is likely not worth much, and therefore assigning that value towards shares in the company is not logical. A convertible note will allow your Friends and Family investors to purchase shares in the company, typically at a discount, at a rate that is determined later on, during the seed or Series A round. The dollar amount gets converted to shares based on what the later-stage investors pay per share, and then the discount is applied to that total amount. For example, an investor pays a dollar per share in their investment. That means the convertible note holder would only pay .80 cents a share if offered a standard 20% discount. The discount is offered as a benefit to those who made the earliest (and likely the riskiest) investments.
Regardless of the approach, if your friends and family are planning to invest in exchange for equity, it is your responsibility to detail the risks involved. Startups are risky endeavors, and as a founder, you are also at risk of damaging your relationships if your early stage investors are not properly educated—and as the founder, it is likely to fall on your shoulders to provide that candid introductory level investor education.
Y-Combinator’s safe templates are a widely recognized agreement for just these types of investments.
3. Don’t Over-Dilute Equity
If there is one key caveat in bringing on investors via early equity shares, it is that the necessity to plan for a cap on equity. In doing so, later rounds of investment will be easier to secure, as the equity won’t be diluted early on.
Equity can be a key driver for early-stage employees, and certainly for future investments. For this reason, it is important to be very mindful of this fact when bringing on early passive stakeholders.
4. Develop Term Sheets and Repayment Plans
If you’re locking in a loan, with or without interest, you need to develop a repayment plan that both parties agree to. By doing so, you reduce risks to your personal relationships, since everyone knows and agrees when the money repayment is scheduled. Having a repayment plan also help set you up for milestone loans. These function such that a particular person will invest an initial amount, and if the business hits a specific milestone (or exceeds it), the lending party will deposit another pre-determined amount of financing. This is a common approach for some later stage investors, too.
As far as developing term sheets, this enters the highly individualized legal territory where you likely want the counsel of a startup lawyer. Developing term sheets, not just for investors, but also for your staff and cofounders, is a necessary element to future fundraising. This helps to ensure that you don’t over-dilute equity. Finally, the term sheet will also state the risks involved, for in the event that your investor(s) do not see any return on their money.
5. Determine How Much You Need
It’s easy to shoot for the moon when you’re riding high and just getting started on building your new dream company—but one of the purposes behind a Friends and Family round is that it’s really meant to be just a kick-start. Rather than estimating the maximum amount of funding you can pull in, think strategically and logically instead. Build a four or six-month plan, and determine how much cash it will cost to buy all the needed inventory and assets, plus any financing you need for early-stage employees. By being very logical with your initial ask, you are in a better position to request additional dollars if the business is still going according to the plan in a few months.
6. Build Your Business Plan
Friends and Family investors typically invest in you and your passion more so than they invest in your actual business. However, that does not mean you should go in with just an idea on the back of a napkin—at a minimum, you need some solid concepts and defined goals. You do not need a well-produced PowerPoint or a big-budget presentation, but being able to communicate clear plans for your first six to twelve months is ideal.
Include how you plan to use the initial funds, what equity options may be available, and of course plainly state the risks. Though you can’t outright determine the value of your idea or business, comparing what you are doing in comparison to either competitors or similar markets may also be a useful component in convincing first investors to write the check.
7. Hone in on the Right People
Receiving a gift or a loan is pretty straight forward, and you can ask practically anyone you trust and who has the available funds. When it comes to equity or convertible notes however, you need to put some more thought into it. Like finding the right investors who will add value in larger rounds, you should determine if these friends and family investors have a professional background, and who really understands the risks and benefits associated with financing your idea.
The Small Business Administration has sound advice on this topic.
Don’t just turn to Dad or your best friend because that’s who you know. Select someone with solid business skills who knows the risks and benefits of what they are getting into. Remember, if your business doesn’t work out and you can’t repay your obligations, relationships will suffer. At the very least, narrow your list down to friends or family who have faith that you will succeed, who understand your plans and are clear about the risks.
8. Ease Them In
Once you have an idea of who to ask, ease them in. Don’t randomly message your friends from college or high school telling them how you’re going to make millions and that they can join in. There are too many MLM schemes and slapdash reseller-wantrepreneurs floating around out there today, that everyone has some heightened caution, and so throwing any red flags can stifle your chances early.
Investing is as much about relationship building as it is selling your startup idea on its merits alone. A few ways to ease a potential investor in is by asking them for input on your concept, and then giving them updates on where things are headed. Having already shown you can communicate clearly and demonstrate early traction as well as openness to their advice, your investors will likely see more value in you as an individual founder, and will be more amendable to considering your pre-seed fundraising pitch.
9. Make the Pitch
When the time is right, make the pitch. In some cases, your investors will outright ask how they can get involved, which will make the process easier. Regardless of who makes the first move, focus on ownership shares, complementary services or products, future discounts, or other benefits you can offer that can also help move the deal towards the close. But most importantly, communicate clearly about your vision, how you are going to get there, and what you can measure to show progress at each stage alone the way.
10. Seal the Deal
Your investors want in and now it’s time to make it official. Fortunately, you’ve already pre-planned for this by determining caps on equity, discounts on convertible notes, and even had agreements signed off on by a lawyer. Now you just need to put it all in ink, have the funds wired to your business account, and continue to make progress on your business.
11. Document Your Financials
Document everything. It’s just that simple. Startups too often put policies and formalities on the backburner, which can result in a much bigger mess later on. By having your financials and agreements in check, future investments will be significantly smoother.
12. Keep Them Posted
Remember, one of the key elements of a Friends and Family round is that these are people you already have a strong relationship with. These investors want to see you succeed, and because of this, it’s an especially good idea to keep these people in particular posted and up-to-date on how things are progressing. This is especially important for those that may have equity shares. Be sure it doesn’t become a distraction that draws too heavily on your time, but once monthly is a very healthy pace to establish early on in building open and ongoing communication with your investors.
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