Raising funds from friends and family often seems like the logical first step for a new business to raise money. After all, you will be hard pressed to find an investor who is willing to shell out funds when your whole business is simply a couple motivated people with a great idea. However, accepting money from friends and family is not as straight forward as it may seem. This article discusses various options for structuring an investment from friends and family.
There are numerous different instruments that can be used to raise money from friends and family. These instruments include debt, equity, or a combination of both debt and equity (see this article for information on debt vs. equity). All debt or equity transactions implicate securities laws, so entrepreneurs raising money through debt or equity will generally need to find exemptions from securities registration requirements (see this article for information on common federal securities exemptions and this article for information on common California securities exemptions). Each approach to a friends and family transaction has significant advantages and disadvantages. Below are a few of the options. These options assume that your business is set up as a corporation, but similar concepts could apply to a Limited Liability Company or similar entity.
It is possible to simply issue common stock to friends and family in exchange for money, but there is a big risk that this seemingly straightforward transaction will have significant negative consequences for your business. The big issue with just providing common stock in exchange for money from a friend or family member is that you are essentially valuing your company at the time of the transaction, which you generally want to wait to do.
For example, when a family member gives you $20k in exchange for 5% of the common stock in the company, you are placing a value of $400k on your company.
This approach has two downsides for the company. First, a premature high valuation can have significant consequences for the business. This can include challenges with both raising future financing and issuing stock options to employees and consultants, as there would be major tax consequences if future stock is issued at a price lower than the value you have previously established.
A second downside with giving common stock to friends and family is that, as owners of the business, they will have certain rights including the right to vote on major decisions, the right to inspect the company’s books, and others. This may prove problematic if the friend or family member is not a good fit for the team or does not provide much value to the business.
For these reasons, it is generally not advisable to simply give common stock in exchange for money from friends and family.
Convertible Notes and Convertible Equity
Convertible notes and convertible equity (collectively referred to as “convertible securities”) allow a company to receive cash from an early investor without the premature valuation issue discussed above. This is because the convertible security holder (i.e. the investor) does not receive company stock at the time she invests, but only the right to receive stock at the time of a future financing (such as a Series A round).
This approach has significant benefits for your friend or family member for two reasons. First, the stock she receives will be on the same terms as later investors, which typically include a number of preferences over common stock holders. Second, she will likely receive a discount and other perks compared to the later investors to compensate her for taking a risk on the business at an early stage.
But there is a significant risk for the company with using convertible securities for friends and family if he or she does not meet the securities laws’ definition of “accredited investor.” This is because the future financing will almost always take advantage of a federal securities exemption that relies on all the investors in the round being accredited investors. Even one investor (including the convertible security holder) who does not meet the definition of accredited investor can destroy the exemption, causing significant securities compliance issues.
Because a friend or family member who holds a convertible security is considered an investor in the later round, he or she will have to meet the definition of accredited investor. In order to qualify as an “accredited investor” your friend or family member will need to either have a net worth of at least $1 million (not including the value of their primary residence), or have an income of over $200k each year for the last two years (or $300k together with their spouse if married) and have the expectation to make that amount next year. Directors of the organization can also qualify as accredited investors, but friends and family members should only be chosen as board members if they will significantly contribute to the expertise of the organization and will be a good fit for the board and for the organization as a whole. For more information on accredited investors, see this SEC bulletin.
Thus, convertibles are a great tool if your friend or family member qualifies as an accredited investor, but it is not advisable to use convertibles for other friends and family transactions.
Common Stock with Promissory Note
Another option for your friend or family investment is a combination of equity and debt. To do this, you would issue your friend or family member common stock at par value (typically $0.0001 or lower at the company’s early stages) as well as a promissory note for the remainder of the funds (i.e. the business accepts a loan).
This approach is beneficial to the friend or family member for two reasons. First, receiving an ownership share of the company means that she will share in the upside of the company. Second, because the promissory note is a debt instrument, she has a right to have her investment paid back with interest.
This approach is also beneficial for the company. Because the common stock is purchased on the same terms as the company’s founders (i.e. at par value), this avoids the valuation issue with the common-stock-only approach above.
From the company’s standpoint, the issue with this approach is that the company is taking on debt, which is not necessarily the best way to get started with a new business if it can be avoided.
Gift from Friends and Family
Another option is to take the money as a gift from your friend or family member. However, gifts are not generally an enforceable contract because of the one-sided benefit of the transaction. Thus, the gift can potentially be revoked by the friend or family member. Additionally, you are going to need to find quite the generous friend to simply give you money in exchange for nothing (other than gratification of being a good friend).
If at all possible, the best way to approach friends and family transactions is to limit the deal to friends and family who qualify as accredited investors and to use convertible security instruments. Barring wealthy friends and family that meet the definition above, the common-stock-plus-promissory-note approach is likely your best option to avoid premature valuation.
Unfortunately, there simply are not many tools available to entrepreneurs seeking to raise funds from friends and family without hitting major risks. Thus, it is smart for founders to bootstrap as much as possible prior to having to raise funds.
First published on Elevate Law and Strategy‘s blog
DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice.