When companies start up, often the first place they look for seed financing is from friends and family. As frequently as they occur, there is very little available on the details of what consists of a “good” friends and family financing. In this post, we will go through some of the considerations for your next friends and family round of financing.
Friends and family financings are frequently the first financing from outsiders of the company. Increasingly though with tough financial times, companies are relying more heavily and for longer periods of time on friends and family support to get them through the early times. So, let us get into some of the details.
Type of Securities to Issue
Almost invariably, when the company is a corporation, the company issues common stock in the friends and family round. For limited liability companies (LLCs), the security issued in the friends and family round is whatever the common stock comparable security is for the LLC—sometimes it is referred to as Class A Units or sometimes it is just a percentage interest or just “units” (if the LLC has only one class of securities). As LLC capital structures are most often a matter of contract per the company’s operating or LLC agreement and the laws vary from state-to-state, there is no single standard name for the type of security.
As later posts will echo, one important point to keep in my mind in terms of deciding on the type of security to issue is the importance of keeping the capital structure simple. In this case, with a friends and family round, it is typically best to issue common stock (or the LLC comparable). While one sees convertible notes, a “stripped down preferred,” or a certain level of warrant coverage, I recommend keeping the capitalization structure as simple as possible, for as long as possible.
High Risk and High Price?
Pricing is often a difficult topic for a friends and family round. In my experience, it is often the round least likely where one is to see negotiation on price. It is not uncommon, however, for the friends and family round to be overpriced. How do I know that? Few would argue that of all the rounds of outside investment that companies go through, the friends and family round is likely where there is the most risk (technical and commercial) and there is likely the fewest tangible and intangible assets. I’ve seen some statistics indicate that over 90% of tech startups end unsuccessfully. Yet, it is (1) very common to see seven (or in some cases, eight) figure pre-money valuations for not much more than a skeleton of a management team, a business plan, and a patent application, license right, prototype, or vaporware, and (2) not uncommon to see either a flat round or better terms offered in the first VC or angel deal following the friends and family financing. It is not that entrepreneurs are trying to take advantage of their friends and family. But rather, it is likely because they are overly optimistic concerning their prospects; they are entrepreneurs after all, and a good sense of optimism is essential to success.
Impact of Price on Subsequent Rounds
When pricing a friends and family round, it is also important to consider the impact of the price in the context of the long term capitalization strategy. I talk about the long term strategy in my earlier post, Capitalization Strategy: Begin with the End in Mind. As mentioned in the previous paragraph, a common problem that some entrepreneurs face is having too high of a price in the friends and family round (or subsequent angel round for that matter). How can too high of a price be a problem for a company? After all, a higher price means less stock is issued and therefore less dilution. The reason it can be a problem goes back to your long term plan. Often, a high price in an early round yields problems in later rounds in terms of existing investor expectations. If you understand the likely pricing expectations of later round investors, those expectations should be incorporated in earlier round pricing. Promising companies can sometimes get too aggressive on pricing in early rounds and often stall, not because of their technology or lack of success in their commercialization efforts, but rather because they cannot find financing sources that meet their existing investor expectations. So, after a considerable delay in not getting a timely financing, companies are forced to consider either (a) “down round” pricing to get the amount of financing they need from subsequent round investors or (b) accepting less investment (most likely from existing investors) and prolonging the current share pricing as they hobble along and exist on less than ideal amounts of financing. Also, by accepting down round pricing, it can not only affect morale of existing investors but also employees as well in terms of the perception of the direction and speed of the company’s momentum.
Effect of Price on Stock Options
On a related note to employees, one other thing to keep in mind is the impact of your friends and family round pricing on your stock option pricing (or other equity-based incentive), especially if you issue common stock in the friends and family round. The price at which you sell your securities will likely affect significantly your stock option exercise price or the amount that has to be taken into income by employees and contractors if stock or other equity-based securities are issued to them. This is especially true as the ability to issue discounted stock options is no longer the option (pardon the pun) it once was in light of tax code section 409A. This is one area where offering convertible notes (or preferred stock) to friends and family yields a benefit over common stock.
Accredited Investor Status
As a general rule, it is best to limit your friends and family offering to accredited investors only. Many companies want to enable their friends and family who are not well off to “get into the action” early. Ignoring the issue of whether friends and family who are not accredited can bear the risk associated with an investment in a start-up, by including friends and family who are not accredited in an offering can drive up your legal costs to do the transaction and increase the risks of legal problems associated with the entire offering. If you are considering including investors who are not accredited in your offering, have a discussion with your attorney first before announcing the offering. Doing so will help to ensure that you make an informed decision without the pressures of the implications of backing down from an earlier announcement to your friends and family.
Amount of Funding
The amount of financing should be driven by, you guessed it, your long term capitalization plan. Conventional wisdom is that you should raise sufficient money to comfortably get you to the next significant milestone that increases your valuation. However, there are some companies that believe that they should get as much money as they can, as soon as they can. The problem with this latter approach is that, assuming your subsequent round financing is an up-round, you will suffer more dilution by getting the money earlier than what you would otherwise experience by waiting and then selling the securities later at a higher price. Also, some people believe that companies can become less efficient, less “hungry,” and lose their sense of urgency with significant amounts in the bank. On the flip side, a benefit of raising more in an early round is that less time is spent on subsequent fundraising. In addition, as those who adopted this approach a year ago will say, they are not now seeking financing in what is a very difficult time to raise money.
Importance of the Friends and Family Round
While typically not the biggest round of financing to say the least, the friends and family financing is essential for most high growth companies. It is important to do the financing right and not fall into one of the easy traps that create problems later in the company’s life cycle. If there’s interest, I can elaborate on some other traps and pitfalls in a later post.