Raising Startup Funds from Friends and Family

Raising funds from family and friends often seems like the logical first step for a new business to raise money. After all, you may be hard-pressed to find an investor (angel investors, venture capitalists, etc.) willing to shell out funds when your whole business is simply a couple of motivated people with a great idea, especially if you are not a repeat founder. However, accepting money from friends and family is not as straightforward as it may seem. This article discusses various options for structuring an investment from friends and family.

How to Structure a Friends and Family Round

There are numerous different types of funding 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.

When raising funds for a startup, you need to be aware of securities laws. Small businesses and entrepreneurs raising money will usually need to find exemptions from securities registration rules. Each approach to a friends and family transaction has significant advantages and disadvantages.

The options in this article assume your business is a corporation. However, similar ideas could also apply to a Limited Liability Company or a similar entity.

See this article for information on common federal securities exemptions and this article for information on common California securities exemptions.

Common Stock

You can give common stock to friends and family for money. However, this simple deal can lead to big problems 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 the common stock of your company at the time of the transaction, which you generally want to wait to do.

For example, when a family member gives you $100k in exchange for 10% of the common stock in the company, you are placing a value of $1 million on your company.

This approach has two significant downsides for the company. 

First, if founders or others were issued stock around the same time as the investment, the IRS likely would consider the stock issued to founders to be issued at the same value and since the founders are service providers to the company, that would mean that the founders either need to pay that same value for their shares or have a tax liability for that value. For example, if a founder received 50% of the company at/around the same time as the $100k investment above (which valued the company at $1 million), the IRS would say that the founder needs to pay $500k for their equity or recognize $500k of income on their tax returns. Not a great way to kick off a company!

Second, equity incentives for other team members would also need to be issued at that same high price, which makes the equity incentives less attractive and less motivating for the personnel you want to incentivize.

For these reasons, it is generally not advisable to simply give common stock in exchange for money from friends and family.
Convertible Notes and SAFEs

Convertible notes and SAFEs, so called "convertible securities," let a company get cash from early investors. This avoids the problem of valuing the company too soon. This is because the holder of the convertible security (the investor) does not get company stock right away and to the extent that the convertible security is considered equity for tax purposes, it has a liquidation preference above common stock so it does not have the same level of tax impact as issuing common stock as explained above. Instead, they only get the right to receive stock during a future priced round, like a Series A financing.

This approach has significant benefits for your friend or family member for two reasons. First, the stock they get will have the same terms as later investors. These terms usually include some advantages over common stockholders. Second, they will likely receive a discount and other perks compared to the later investors to compensate them 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 investors if they do 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. 

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 current fair market value (which can often be $0.00001 per share for new companies) as well as a promissory note for the remainder of the funds (i.e. the business accepts a loan). This approach is admittedly less common and is not the best from an optics perspective for future rounds, but it can work if it is the only capital available. 

This approach is beneficial to the friend or family member for two reasons. First, receiving an ownership share of the company means that they will share in the upside of the company. Second, because the promissory note is a debt instrument, they have a right to have their 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 business startup if it can be avoided.

Takeaways

If possible, the best way to handle transactions with friends and family is to limit them to accredited investors. It is also wise to use convertible security instruments. If you do not have wealthy friends or family, the common-stock-plus-promissory-note method is probably your best choice if it is the only capital available. This approach helps you avoid an early valuation.

Contact us to discuss how to structure your friends and family round.

DISCLAIMER: The information in this article is provided for informational purposes only and should not be construed or relied upon as legal advice. This article may constitute attorney advertising under applicable state laws.