In the search for start-up capital funding, there can be quite a few advantages to going to friends and family for your source of financing. They know your strengths and capabilities and may take a chance on you when banks or investor funding may not be readily available. Also, this source of money may be available when other money is not. For Founders having trouble with cash flow or don’t have the collateral or revenue to attract a bank or professional equity financing, this could be your only source of start-up capital. This initial investment source can help in launch a new venture or serve as bridge funding until venture capital investment comes through.
ADVANTAGES FOR THE START-UP FOUNDER
Raising money from family and friends has a number of advantages, especially as compared to other financing alternatives.
For instance, private loans may have more Founder-friendly terms than other traditional sources. Founders may also be able to structure convertible notes and preferred share investments with more favorable terms than commonly found with early investor seed money. Founders might be able to make more flexible arrangements regarding payback, including paying lower interest, grace periods, or graduated payments, than through traditional lending sources.
Importantly, raising money from friends and family shows validation from key supporters. The start-up phase of a new business can be a very stressful and doubt-filled time, and having friends’ and families’ financial support shows belief in a Founder’s ideas, which can make all the difference in those early days.
FREQUENTLY ASKED QUESTIONS
Below are some of the most common question IBV Advisory Group Inc. encounters when representing Founders and investors. We stress that these are concise answers to complicated question and should be used as a basis of discussion with a qualified start-up business attorney. As the initial investors are family and friends, structuring any financing for a start-up business must be done carefully to preserve relationships, and any investor should fully understand the risk of getting involved.
1. How Does a Start-Up Founder Structure an Investment from Family & Friends?
There are a few different ways that an investment can be structured. One of the most basic ways that family and friends can invest is through a loan. While it may be basic, it may not be practical, as many start-ups cannot afford to pay back interest (or very much else) for the first few years. As an alternative to a traditional loan, Founders may issue either convertible notes or preferred shares to investors, keeping the common voting stock for themselves.
2. What is Convertible Debt?
Convertible debt is a somewhat complicated financial product that is debt (like a loan) that converts to equity (usually preferred stock) based on some trigger (usually a venture capital funding round). The debt usually accrues interest but the interest is not paid until the trigger event occurs. Once the trigger event occurs, the debt holders can convert the money loaned and accrued interest to preferred stock, which can usually be purchased at a discount. Preferred shares are equity stock and the stock is usually non-voting. A number of features can be added to the preferred stock (eg. right to appoint board members) to give investors comfort. Both Preferred Stock and Convertible Notes are financial securities and require extensive legal advice and documentation to set up.
3. Should a Founder Sell Preferred Shares or Convertible Debt to Friends & Family?
Many start-up Founders ask the question of whether or not they should issue convertible notes or preferred stock to investors. Convertible debt has the advantage of being a bit cheaper as the legal set up is not as complex. In addition, convertible notes push off the valuation of the company to a later date (usually until a venture capital fund comes along). The downside is that some Founders who have never raised capital before find explaining the concept of convertible debt to investors difficult.
Preferred stock is a straightforward solution to explain to investors but can cost more in legal fees to set up at a point where cash flow is still an issue. Preferred stock may be a difficult solution as it requires an initial valuation, which in many instances is highly speculative. Many companies do not have established income streams at such an early stage, and in cases involving seed funding, a minimum viable product may be months away. This could cause complications as the valuation is going to be the basis for the price that an Investor pays for their shares.
The purpose of this article is not to give a definitive answer on whether preferred stock or convertible debt is better than the other. Determining which investment vehicle is best requires an assessment based on individual facts and circumstances of the start-up by a qualified attorney. The right structure can also vary in different industries. For instance, structuring a tech start-up venture can be very different from structuring financing to open a restaurant.
Regardless of the investment structure, there are a number of legal documents which must be prepared as well as ongoing SEC compliance.
4. Does the Founder need to follow SEC regulations when friends and family are involved?
Yes, Founders are required to comply with the Securities Exchange Commission (SEC) regulations with the sale of any stock. The term “security” is defined by statute but most financial products that a company can sell to an investor would qualify as a security, such as preferred stock, convertible debt, member units, or common stock. In addition to federal SEC requirements, a company that issues securities would also have to comply with State Securities regulations (aka Blue Sky Laws). These regulations have been set up to protect investors from fraud and require a company to provide the investor with information such as financial statements, offering documents, prospectuses and other information so that an investor can make an informed decision.
5. How much Information must be provided to friends and family investors? Is it as much information as if the offering were to be made to the general public?
If offering securities to friends and family, Federal and state exemptions may be available and can usually be filed so you can limit the amount of information provided to investors.
If the financing does not qualify for the exemptions, a Founder would need to provide much more than a business plan and any other information on hand. If an exemption is not available, full SEC disclosure requirements kick in and Founders are required to provide investors with an extensive set of information including offering documents, audited financial statements, prospectuses and more. The exemptions are complicated and rules often limit who you can sell securities to and place restrictions on the securities that are sold. For example, some exemptions require that your friend and family investors be “Accredited Investors” such that they have significant financial assets and superior knowledge of financial markets.
6. What happens if SEC Regulations are not followed?
When a company or individual that has issued securities has failed to follow U.S. law, they may be subject to sanctions, including prohibition of future securities issuances, fines or imprisonment. Founders must also ensure that they do not provide false or misleading information to investors, as such Securities prosecutions can result in both fines and imprisonment.
7. Can a Company pay employees with stock?
Yes, but Founders should not do so without the advice of an experienced attorney, as this is a highly complex area. As stock is a security, any issuance must comply with Securities Exchange Commission (“SEC”) regulations as well as each state’s blue sky laws. In addition, setting up a stock option plan can have complex tax implications which would need to be addressed as well.
8. Is a Lawyer Needed to Raise Funds From Friends & Family?
Yes. Unless your friends and family are giving you a loan, you are most likely issuing securities to them. Securities law and regulation are complicated and an attorney should be retained to ensure compliance with state and federal requirements. An experienced attorney will also put a legal framework in place to handle compliance issues in a variety of contexts down the road.
If you are considering issuing securities to friends and family, contact IBV Advisory Group Inc. for a consultation. You can call us at 310.746.3837 or email us at Evelyn@IBVAdvisoryGroup.com.