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For a start-up, initial capital can mean the difference between two founders with just an idea or two founders with a beta product that has real users and could even become the next Uber. While investments from friends and family can be crucial to getting your business off the ground, such investments also come with an additional set of responsibilities. After all, these are the people you grew up with, run into at gatherings, and perhaps even call your father-in-law. Said differently, it is always important to remember you have pre-existing personal relationships with these people that likely trump any need for capital. To that end, below are some important considerations to keep in mind when seeking capital from your friends and family.
1. Be Honest: The great thing about a friends and family round is that these potential investors already know you and have faith in you. They want you to succeed and want to believe that your idea has the potential to make an impactful change. As a founder, however, you should not take advantage of this faith. You should educate these potential investors of the risks associated with investing in start-ups broadly as well as the specific risks unique to your business. Just as important, if you do receive an investment, be sure to provide periodic updates on the status of your business.
2. Explain Investment Terms: Your friends and family may be sophisticated lawyers, doctors, engineers, consultants and so forth, but that doesn’t mean they are sophisticated early-stage investors. Take the time to create a term sheet and lay out exactly what form the investment will take and make sure to explain what that actually means to your potential investors.
While there is a lot of literature on common investment structures for start-ups, like the classic convertible note or the newer SAFE or KISS, your friends and family investors may think they understand the structure when they actually don’t. For instance, an unsophisticated investor may see the interest rate and maturity date associated with a convertible note and think – “Worst case, I’ll get my money back with interest in a couple of years if this doesn’t work out.” The truth is, however, that if the start-up is unable to grow sufficiently before maturity, chances are the investment amount won’t convert into equity because the start-up has failed to raise additional institutional capital, or alternatively, the start-up won’t have sufficient liquidity to pay off the loan.
3. Documentation: A founder should treat an investment from friends and family like an investment from a stranger and should appropriately document the transaction. Documentation does a couple of things: (1) it clearly spells out the intention between the parties and (2) captures the rights and obligations of each party.
4. Offer Fair Terms: Investors in a friends and family round are taking a big risk (if that wasn’t clear from the above) and should be compensated accordingly. As a founder, you should take the time to understand what terms are fair and reasonable given the amount of risk undertaken and offer investment terms that balance such risk. The last thing you want to do is take advantage of your relationship and the trust and offer terms that are less than fair.
Tej Prakash is the co-founder of ShouldiSign.com, an online legal marketplace that helps individuals and businesses find and engage pre-vetted attorneys in a transparent environment. Prior to co-founding Should I Sign, Tej was a corporate attorney at Willkie Farr & Gallagher LLP and then Kleinberg, Kaplan Wolff & Cohen, P.C., specializing in public and private mergers and acquisitions, private equity and venture capital transactions and general corporate and securities law matters. He also has experience serving as an advisor to start-up companies.