Financing Options: Friends and Family

This is the first in a series of posts about financing options for startups. By “financing” I mean obtaining cash to fund your business. There are all sorts of strategies to avoid needing funding, but this series is not about them.

Many entrepreneurs turn to friends and family for their first funding needs. In fact, it is common for non-tech startups to raise all the capital they need from friends and family. I don’t know for sure, but I would suspect that friends and family make up the largest source of funding for entrepreneurs and startups.

Friends and family financing is popular because it is easy to get a hearing from the people who know you best and they are positively inclined to say yes. But there are some negatives as well. It’s tough to know how to price and structure an investment where the investors are close friends or family. You don’t want to take advantage of them and they may not be sophisticated enough to know what is a good deal and what is a bad deal.

And friends and family often cannot come up with a lot of capital so unless your business doesn’t need much funding, this will not be the only round you do. But friends and family can get you into business and give you some time to create value that other investors will recognize and value.

Probably the most tricky part of friends and family financing is that you really don’t want to lose money that friends and family have invested with you. And most startups fail so the chances that will happen are high. I would encourage entrepreneurs who take funding from friends and family to be very clear about the risks and downside. I would also suggest only taking capital from friends and family members who can afford to lose the investment. That way, if the investment does turn out to be bad, at least you won’t lose valuable relationships. Even so, it is easier on the mind to be doing a startup when your capital comes from professional investors than your loved ones.

I would recommend doing friends and family financings as convertible notes with a discount and a cap on the valuation. That way you don’t have to worry about how to price the investment. A 20-25% discount from the next round is appropriate. The valuation cap is going to vary depending on the size of the raise and the size of the opportunity. I’d suggest a cap that gives the friends and family around 10% of the business if things work out. But that is just a suggestion. A 10% interest will not be appropriate for every friends and family investment.

Friends and family funding is the most common form of startup financing but also the most tricky in many ways. Be careful to do it right because there’s a reason why these people will back you when nobody else will.

 

From the comments

Charlie Crystle added:

My dad funded my first company $20k. When I wanted to experiment with something that would take $7k, he invested that. That became ChiliSoft 2 months later; he didn’t live to see it, and I Imagine that drove me through a lot of challenges.

That said, I don’t think I’d take money from family again. I prefer investors I get to know rather than friends & family, because the emotional toll can be significant when things are rocky–and they will get rocky.

Here are the rules for friends:

1) It must be money they’re willing to lose. The reality is you feel obligated to return their money anyway, so it’s basically a debt.

2) They must agree not to stop in the business as they please. They get monthly email updates like any other investor (with metrics, etc–saves a lot of time). 3) It’s important to limit the number of F&F investors–gets complicated quickly, and you can bet you’ll need to go back to the well a few times because, well, you’re almost never right about growth or closing an investment.

4) What could possibly go wrong? They disagree with your decisions, like firing someone they are friends with or attempting to get involved in later financings. Christmas one year almost didn’t happen because I stuck to my guns about a necessary firing.

5) They’ll like you when you win. Not that they won’t if you lose, but in between can get murky.

Try raising from customers–sell something. If it’s a consumer internet play, that’s tougher, but try to have something in place so you don’t have to keep going back to the well.

 

This article was originally written by Fred Wilson on May 30, 2011 here.