Friends and Family: A Huge Source of Capital for US Startups

November 20 2010 5 Commented

The following article appeared in the December 2009 issue of the Flathead Business Journal, but is no longer available online.

Using cash from friends and family to start businesses is a quite common practice.  It is estimated that roughly half of startup entrepreneurs get financial support from friends and family members in starting their companies.  According to the Global Entrepreneurship Monitor (Babson & London School of Business), $50 to $75 billion is invested annually by friends and family in US startup entrepreneurs.  This is two to three times the amount of money invested annually by either angel investors or venture capitalists – each of which invests approximately $20 billion per year in new businesses.

Just who are these “friends and family” investors?  Entrepreneurs commonly pursue investment from anyone they know personally who can afford to make the investment, such as parents and grandparents; aunts and uncles; neighbors; and even their minister and high school principal.  These friends and family members will invest in your business because they believe in YOU, that is, the entrepreneur’s demonstrated work ethic, integrity, curiosity and passion to succeed.  These “friends and family” investors usually lack adequate business savvy to either evaluate the investment opportunity presented or advise entrepreneurs on growing their business.  In fact, they are not investing in your company…they are investing in YOU.  Sit down with candidate friends and family investors, explain your business plan to them and ask for the money.  You will be surprised with your success.

BUT…don’t just accept their checks with a grateful thank you.  Discuss the nature of their investment…and then document each investment in writing.  Is this cash a gift?  Is this a loan?  If a loan, what are the terms and conditions of the debt?  Is this an equity investment, for which the investor expects shares in the company?  If equity, for what number of shares in the company?  While these questions seem trivial at the outset, they may become critically in the future.  If you and your friends and family investors do not decided in advance, you may be allowing this investor to decide later.  If she then decides the investment was debt and the company fails, then your dear old Aunt Emma may still want her money back from you personally!  On the other hand, if she later decides the investment was equity and the company is successful, then just how much of the company does Aunt Emma own of your new company?  The author is not advocating a position (gift versus debt versus equity); instead I am urging entrepreneurs who accept friends and family investment to clarify the expectations of the investor.

One of the biggest mistakes entrepreneurs can make is neglecting to clarify the relationship with friends and family investors.  Whether this business succeeds or fails, relationships with friends and family are important to maintain.  Entrepreneurs routinely successfully pursue funding from friends and family.  Friendly advice:  Clarify the nature of the investment at the outset!

5 Responses to “Friends and Family: A Huge Source of Capital for US Startups”

  1. I’ve done this, at least getting my first startup off the ground. When I had enough money myself, I immediately bought them out to relieve them of the burden. My advice…

    1. Even if they are willing, don’t take friends and family money from people that you don’t think can afford to lose it.

    2. Treat them as professionally as shareholders as you would a VC or other fund. This is good practice, for one. Secondly, it’s the right they’ve earned.

    3. Set expectations up front about involvement. Shareholders get to vote on certain things. They don’t get to stand over the shoulder of the CEO.

    Jamie Flinchbaugh
    http://www.JamieFlinchbaugh.com

  2. admin says:

    Great comments, Jamie! Thanks.

  3. Tyler says:

    Good post. Question: how do you put a valuation on family/friends rounds? How do you make the calculations and how do Angels/VCs view those investments and valuations?

  4. admin says:

    Thanks for your comments, Tyler! Let me respond to each of your questions:
    1. How does one value friends/family rounds? I think the simplest vehicle is a convertible note. Then, convert the F&F investors under the same terms and conditions as the next round of funding. But, if you feel you must establish a valuation for common stock, make the price really low. Give F&F a good deal, say 10% of the company for $50,000 in funding.
    2. How do you calculate valuation for F&F rounds? It is pretty difficult. But, look through the several valuation methodologies in my blog (Scorecard, VC, Dave Berkus, Cayenne Calculator and Risk Factor Summation) and see if those help. The other option is to simply pick a low number and use it.
    3. Angels and VCs don’t get too nervous about a few (say 5-10) F&F investors investing at a low price. But, professional investors would like to avoid deals with a large number (more than 25) friends and family (unaccredited) investors. Angels and VCs also don’t want to see F&F investing at high valuations, especially if the professional investors would like to invest at a lower price. Cramming down F&F doesn’t make anyone happy. Perhaps, convertible debt for F&F is the best solution.
    Bill

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