Friends and Family: Raising Early-Stage Investment
There is no dearth of challenges for an early-stage startup; there is simply too much on the plate. However, one of the biggest headaches a founder faces is getting the initial cash to get the business going. While loans and personal savings are always the go-to, they are on the lookout for people who can invest in their vision in the very beginning.
Professional investors like angels and VCs typically choose to come in the slightly later stages, once the startup is up and running. So where can entrepreneurs look for help? Their network of friends and family, people who they already enjoy good relationships with.
The Friends and Family round (F&F) is one of the first rounds of funding for a startup that allows it to become operational and cover initial costs. While this seems to be the easy route to startup financing, different aspects need to be considered by all stakeholders.
Sharing all the information
Entrepreneurs must understand that their friends and family are undertaking a lot of risk by investing in the startup. When there is only an idea on paper, there is no way to judge how well it will do going forward.
As the founder, it becomes your duty to firstly help everyone understand the risk involved and secondly, share all information about your venture so that they know what your idea and vision are. Do not shy away from having proper pitch decks shown along with your financial projections so that there is enough material for your friends and family to take a call.
The decision to invest in a startup is not one that can happen over a casual dinner table conversation. All those involved must know that there is a greater chance of them losing their money. They should also be aware that even if they do get a return, it will not happen anytime soon, i.e., it will take more than 5-7 years at the very least. Therefore, it is critical to clarify these aspects before proceeding with round terms.
Choosing the right instrument
Once all the information is out there, it is time to decide the financial instrument you will use for the round. The money through F&F is generally raised in three different ways, i.e., via debt, equity or gift.
If you choose the option of debt, you essentially take a loan from an individual with a promise to pay it back with interest within a certain amount of time. While it is an excellent way to maintain a clean cap table, it requires the company to have enough cash flow to make room for the repayment and sustain itself at the same time.
The next option is giving equity in exchange for money, just the way you would do for any institutional investors. However, at such an early stage, an equity round involves certain bottlenecks. Since it is the first round of investment, the assumption is that more money will have to be raised going forward. This puts a question mark on the dilution and stakeholding in the company such that it does not have any adverse effect on future rounds.
Secondly, because the company is just starting out, it is hard to put a number on the valuation, something that again has implications when other investors come in at a later stage. Not everyone who is pitching in money would know the legalities associated with stakeholding and ownership, which will become an added burden. If you choose to go for equity fundraise, ensure that all aspects are considered well in advance.
The last option is a gift, which is an ideal scenario for any entrepreneur. This involves financing towards the business without any strings attached, i.e., no equity or repayment. It is driven by pure belief in the founder and his or her vision.
Regardless of the option you choose for the F&F round, it is necessary to have legal documents in place. Do not get swayed by emotions and have a verbal agreement. Having everything down on paper will make the process far more convenient for everyone.
Why F&F is a good idea
- Easy and Quick: Tapping into your existing relationships gives you a better shot at getting the money you need and that too on time. Your friends and family have probably seen you over the years and are better aware of your skillset. It is a relatively easy task to convince them to invest in your vision as compared to professional investors. You have the added advantage of the money being wired in quicker- within two months on an average.
- Less Mental Burden: It should be your absolute priority to not default on any contract terms. However, when it comes to friends and family, you may experience less of a headache in the case of extreme or unforeseen circumstances because they will most likely help you find a way instead of enforcing added legal burden. The same goes for achieving set milestones- they probably won’t give you a hard time for being a couple of months off target.
- Easy Negotiation: It is quite likely that you will get the terms of your liking in an F&F round because these people are your well-wishers and would go the extra mile to allow you the freedom to achieve your goals. This is generally hard when institutional investors are involved. You also get people who are more interested in your business and success and will help you navigate through the tough challenges.
Words of caution
- Things Can Go South: The problem with mixing business and relationships is that you just cannot predict when things will go wrong and how people will react to them. While some people take it in the stride and spirit, your relationship with others may go sour pretty quickly. This again points to full disclosure well in advance about the inherent risks involved in undertaking such an investment.
- Less Objective Advice: When it comes to the F&F round, the biggest enemy is emotions. People that are close to you may refrain from giving business advice or telling you where you are wrong simply because they do not want to clip your wings. The lack of objective advice at this early stage can prove harmful later on.
- Risk of Wrong Terms: As suggested earlier, startups will generally go on to raise rounds after the F&F. However, entrepreneurs run the risk of having excess debt burden, exaggerated valuations and a haphazard cap table which spells trouble for institutional investors. It is always a good idea to take advice from the right people before undertaking investment from your network of people.
The bottom line
The F&F round is indeed an attractive proposition for early-stage startups, especially those who want to build something concrete before knocking at the doors of angels and VCs, to skyrocket their growth. The key to an F&F round lies in balancing passion and practicality. Do not take this money you get for granted; you need to show progress and growth for the sake of everyone who took the risk of investment.
If used correctly, financing your early growth through friends and family can reap great rewards. It is a learning curve like no other and will give you the right base to build on.
