For some companies, fundraising must happen early on, before the start-up even introduces a viable product in the market. Unfortunately, even more challenging at an early stage to convince traditional investors to join to an initial funding round. For that reason, start-ups 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 start-up to get through its first few months of operation. 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 fuelling your start-up 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. At a pre-seed level, excluding the bootstrapped companies that have been around for a while, these Friends and Family round start-ups will have little to no revenue prior, and maybe some LOIs from prospective customers. Luckily, friends and family often will not 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 evaluation criteria. In a Friends and Family round there are several ways that those around you can contribute to getting your start-up operational. 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. Like gifts, loans are relatively straightforward in a Friends and Family round. 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. It is also important not to dilute the number of shares available, if you plan on seeking formal investors in future rounds. It is 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 start-up 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, 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. 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. 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. These function such that a particular person will invest an initial amount, and if the business hits a specific milestone, 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 start-up 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 do not over-dilute equity. 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. Friends and Family investors typically invest in you and your passion more so than they invest in your actual business. 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.
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. 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.
Do not randomly message your friends from college or high school telling them how you are going to make millions and that they can join in. Investing is as much about relationship building as it is selling your start-up idea on its merits alone. 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. In some cases, your investors will outright ask how they can get involved, which will make the process easier. Start-ups too often put policies and formalities on the backburner, which can result in a much bigger mess later. Remember, one of the key elements of a Friends and Family round is that these are people you already have a strong relationship with.
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