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October 16, 2014 | BusinessFrom the blog

Navigating the Friends and Family round of startup funding

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Whether you’re paying rent, payroll or a plethora of other operating expenses, launching a startup requires capital.  When Wall Street VC firms and angel investors aren’t knocking down the door with sacks full of money, many entrepreneurs turn to their closest social circles for a so-called “Friends and Family round” of fundraising.

Family members and friends back startups more than any other group of investors.  In 2012 alone, they provided over $60 billion to a whopping 38% of new U.S. businesses.  If you’re considering a Friends and Family round of funding for your own business, keep these three points in mind.  

1.  Make an accurate valuation.

Although valuing your startup is far from an exact science, it’s important to provide your friends and family with an accurate estimate of the business’s worth before soliciting investments.  Failing to do so can create serious problems down the road.

An overvaluation is unfair to your friends and family members.  Many just don’t possess the business sophistication or know-how to determine whether your valuation is reasonable.  If your company is found to have a lower value in future rounds of fundraising (a “Down Round”), you’ll have to sell more shares to get the same amount of cash, which will dilute the equity of your Friends and Family round investors.

Overvaluing your startup can also have a negative impact on future fundraising rounds.  Some venture capitalists won’t provide funding to an overvalued business until its equity is reallocated to properly reflect friends’ and family members’ investments.  This burden can be costly and time-consuming and might have adverse tax implications.  Other investors may avoid the hassle altogether and wash their hands of your next funding attempt.

2.  Watch out for securities laws.

Securities laws were created to protect unknowing investors from being scammed into funding worthless (and sometimes nonexistent) enterprises.  Offerings of stock, convertible notes and other securities are governed by both federal and state laws, and navigating the maze of conditions and restraints that they impose can be a daunting task for first-time business owners.  A common misconception exists among many business owners that investments by friends and family members won’t trigger securities requirements, but this is not always the case.

As a general rule, the sale of securities must be registered with the U.S. Securities and Exchange Commission (SEC) and comply with other federal rules, as well as additional requirements in every state where an investor resides.  This complicated process can include the preparation of financial statements, prospectuses, offering documents and other paperwork concerning the securities offering, the business and its managers.

However, a number of exemptions exist for businesses selling securities, including the SEC’s Regulation D exemptions.  Over 99% of the funds raised through Regulation D are conducted under Rule 506, which preempts a number of state law registration requirements and provides (among other requirements) that a company may raise an unlimited amount of money and won’t have to register its securities offering if it:

  • restricts its offering to “accredited investors” and no more than 35 “sophisticated” but non-accredited investors;
  • offers “restricted” securities that can’t be sold for at least a year without registration;
  • gives non-accredited investors certain disclosure documents typically used in registered offerings;
  • refrains from marketing the offering through general advertising or solicitation; and
  • meets Rule 505 financial statement requirements.

Bottom Line: Almost every type of investment in your company, including those of friends and family members, should set off securities law bells and whistles.  Even if your business is eligible for federal or state exemptions, a number of reporting and notification requirements typically remain in place.

3.  Let professionals take care of the paperwork.

Fundraising agreements and securities paperwork can get very complicated.  Seeking the assistance of an experienced business attorney can help position your startup for success and prevent a lot of headaches down the road.  Jody Porowski, a successful entrepreneur who raised her business’s entire first round of funding through friends and family, has these words of advice:

There are a lot of legal ins and outs of fundraising and you don’t want to mess things up.  Legal mistakes can come back to haunt you, including having a negative impact on future rounds of funding.  Professional investors do not want to deal with your messy legal jobs or complicated family dynamics.  Keep it clean, keep it simple, and think long term!

Likewise, business owner Jamie Pennington points out how a legal intermediary helps to preserve healthy personal relationships with the family members and friends who fund your startup: “Doing business on a handshake is wonderful, but when it comes to people investing in your company, hire a professional firm to do the paperwork.  This also serves as separation between you and your friends when it comes to the details of the deal.”

After all, your Thanksgiving dinners are already dysfunctional enough.

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