In their passion to succeed, too many entrepreneurs treat friends and family investments as “low-hanging” fruit, only to find out later, after a stumble, that the pain of lost relationships is greater than the loss of their beloved startup. Other entrepreneurs never start their adventure, because they can’t face the prospect of even approaching friends and family for an investment kick-start.
The only way an entrepreneur can really dodge this issue is to totally fund the startup with personal funds (bootstrapping). Then you don’t have to worry about the fact that most angel investors and venture capitalists won’t take a bet on you if none of your friends and family have given you a vote of confidence with money.
This is a sensitive and critical area for new entrepreneurs, and it’s important to get it right the first time. Brian S. Cohen and John Kador, in their classic book “What Every Angel Investor Wants You to Know,” includes these best points of practical advice I’ve seen recently on this subject:
Manage expectations before the fact. Even if you passionately believe that your idea is a winner, it’s smart to remind friends of the historical facts with startups. More than 50% fail in the first two years, and even the “overnight successes” take six years on the average. In the interim, there is no market for the shares, and no dividends or interest.
Make sure the money is discretionary. If friends and family are still willing to take the risk because they believe in you and love you, you need to be convinced that they can afford to lose it all without major impact, and their emotion won’t generate unreasonable expectations over time. If you are not sure on this matter, then don’t take their money.
Be professional about it. Treat the transaction as you would expect to be treated by an Angel investor or VC. That means writing down and signing the terms of the agreement, after making sure everyone understands them. Insist on paying market rates for commercial loans, since the IRS can instigate some nasty consequences on “gifts.”
Tie payments to your product or service revenue. Try to avoid obligations with fixed repayment schedules. With “cash flow” obligations, investors receive a percentage of your operating cash flow (if any) until they have been repaid in full, or have achieved a specified percentage return on their investment.
Loans are a safer option than equity. Offering debt is better than offering direct equity, especially in early stages when you have no valuation for setting equity percentages. Many use a convertible loan note that may be converted into equity upon the closing of the first formal Angel or VC round of financing, with a more realistic valuation.
Pay the money back, with thanks, as quickly as you can. This money is real, so don’t assume it doesn’t have to be repaid. Some founders are too focused on quick repayment, and they compromise strategic decisions. That’s why it is better to use institutional investors and loans when you are able, with realistic time frame expectations.
Don’t forget a couple of additional potential negative realities. For entrepreneurs, friends and family money usually represents the smallest increment of funding, yet requires the most time to manage. Everyone wants to keep up and even have a say in your activities, and that can be a lot of conversations to manage.
A second harsh reality for entrepreneurs is the realization of how little power you have to protect the position of these early investors. New money from professional investors sees lesser value in old money, so the equity of early investors is “crammed down” and often lost in the scale-up surge. Later investors all think you have given away too much of the company too soon.
These realities are part of the reason that this first tier of very early investors are often referred to as “friends, family, and fools.” Most experienced entrepreneurs and investors can recount a horror story of families and friendships torn apart by money lost on someone else’s dream. In these cases both the entrepreneur and the friends are the fools. Don’t be one or create one.