88. Talking to friends and family about investing in your startup.
The first money you raise for your startup will probably be from people who already care about you and your success, your friends and family.
The friends and family (F&F) round usually happens before most angels or VC would consider investing in you, often when all you have is an idea and passion.
People who already know you may be allowed to invest in your startup even if they are not accredited investors. This can vary from country to country and state to state, so check on the legalities in your jurisdiction. However, they probably don’t know anything about investing in startups, so you must help them understand the process and protect their interests.
I made a video you can share with potential investors explaining how it works, the terminology, and the most common deal structures. You can find that HERE. 👈
Ethics matter any time you are taking investments, particularly when it is from friends and family. Don’t screw them over or paint an unrealistically optimistic picture of your business. It could lead to some very uncomfortable family gatherings and potentially destroy these relationships. You need to make sure they fully appreciate what they are getting into.
The Friends and Family Round
When people invest in your F&F round, they buy one of four things: preferred stock, common stock, a convertible note, or a SAFE.
I am not a fan of giving out stock in this investment round. Common stock is simple but disadvantages these investors compared to later investors who typically receive preferred stock with special benefits and protections.
However, negotiating the terms of preferred stock is beyond the experience of most F&F investors, requires lawyers, and can get very expensive.
Both SAFEs and convertible notes let you avoid both those issues. They are not stock but turn into stock when a sophisticated investor leads a larger round later. That investor will negotiate all the terms. The SAFE or note holders get the same stock with the same terms.
Both SAFEs and convertible notes are widespread and standard instruments, minimizing the time and cost of legal advice.
SAFE stands for Simple Agreement for Future Equity. It was created by a startup accelerator called Y Combinator. It is free and only requires you to fill out a few simple terms of your deal. It may confuse your investors because they are not buying anything concrete. It is a legal contract to give your investors some amount of stock to be determined in the future.
Convertible notes are usually easier to explain because they are loans, which are familiar. The strange thing is that you don’t intend to pay them back. The plan is for the loan to turn into stock, wiping out the debt.
Both SAFEs and convertible notes have a few standard terms:
The amount of the investment
Conversion triggers
Discount
Cap
Interest rate (only for notes)
The amount of the investment is obvious.
The conversion trigger specifies what kind of later investment will cause the note or SAFE to convert to stock. Usually, it is when the company sells a threshold amount of stock. For example, the conversion trigger might be when the company sells shares worth $1 million or more.
The discount gives your F&F a better deal than that later investor. That is fair because they took a bigger risk by investing so early. Discounts usually range between 10% and 50%. You should offer a generous discount if you don’t expect to raise more money for a while.
With a 50% discount, if the triggering investor pays $10 per share, your F&F would only pay $5.
However, that’s not always fair. A company at the idea stage might be worth about $1 million. A few years later, it might be worth $20m. If the conversion happened then, assuming a 50% discount, your early investors would be buying at a $10m valuation.
That is where the cap comes in. The cap sets a maximum effective valuation for your company. Suppose you have a $2 million cap and a 50% discount. If the next round is at a $1.5 million valuation, your F&F will invest at $750 thousand. However, if the next round is at $20 million, they invest at $2 million. They always get either the discount or the cap, whichever is a better deal for them.
Interest only applies to convertible notes. The balance of the loan grows at that rate until the conversion. 10% interest is common. Unless the conversion does not happen for years, the interest rate is not terribly important.
One less common option, but something I suggest, is giving your F&F “most favored nation” status (MFN). With MFN, if another investor negotiates a better deal before the conversion event, your F&F gets it too. It ensures that they don’t ever feel like they got screwed.
Talking to your friends and family
Founders often have trouble explaining startup investing to their F&F. They often get pushback or create false expectations.
The most important thing is to ensure they understand this is not a loan you will repay. This is an investment. If the company succeeds, eventually they will be able to sell their shares at a profit. Most F&F don’t focus on this because they are primarily interested in helping you rather than generating a return. However, if the company fails, and most startups fail, they will lose their entire investment. That can be a shocking outcome if they are not expecting it. Make sure they can comfortably afford to lose this money.
They also need to understand that the investment is illiquid. Unlike investments in mutual funds or the stock market, where you can buy and sell at will, startup investments are locked up. Typically nobody can sell their shares until the company goes public, is acquired by a public company, or is acquired for cash. For investors in the F&F round, that usually means five to ten years. Don’t let them invest any funds they might need in the short term.
These conversations can feel like anti-selling, almost like talking them out of the investment but for the sake of your relationships, make sure they fully comprehend the downside. However, if you succeed, it will largely be because of their investment in you early on.
Explain how you will use their money. Show them that this is not personal play money but something that will contribute directly to the growth of the business. Additionally, discuss the specific results and milestones you plan to achieve with these funds.
Let them know their ownership will shrink as you issue options and take in new investors. This can seem odd. If you own 50% of a house, that does not change unless you sell some of your interest. With a startup, if they start out owning 10% of the company, they might only own 7% after the next round and maybe less than 4% by the time you exit.
They need to understand that this is a good thing. You are issuing options so you can hire the best people who will grow the company. You are selling shares to raise capital to accelerate that growth. After all, you should never be giving away equity unless you firmly believe that the resulting growth in the company will vastly outweigh the dilution you experience.
Finally, don’t stop communicating once they sign that check. Keep them in the loop. Send them your investor update emails. F&F want to see you succeed. Watching you grow and thrive is one of the biggest rewards of early-stage investing. Don’t short them on that. Let them be part of the experience.
Until next time, ciao.
