After maxing out their credit cards, many founders raise their first investment money from friends and family. To avoid future problems, founders should be aware of key legal and relationship issues.
“Paper” the Deal: When the amounts invested are small, there can be a strong inclination to just take the money and deal with the paperwork at a later date. But it’s essential to have the investment recorded in proper legal documents. People’s memories of the specifics will diverge over time, and disputes will inevitably arise over what was agreed upon. Also, investors in subsequent rounds must know exactly what they are buying into, so the company needs to be able to unequivocally show them the number of shares, and related rights, of the first round investors.
Deal Structure: Friends and family investments usually involve less than $500,000, the levels at which experienced angels and some investment funds will get involved. This puts a premium on keeping the transaction simple, so legal fees and the management time devoted to doing the deal are minimized. Typically, the investment takes one of two forms: simple common stock in return for cash, or a convertible arrangement, where the investor’s money is converted to stock at a later date, or else repaid as a loan, with interest.
The conversion is often done at a price per share based on what the investors in the subsequent, larger round pay, but with a discount to reflect the added risk assumed by the “friends and family” investors. Realistically, if the company does not succeed in raising subsequent rounds, it won’t have the money to pay back a loan, so the loan aspect of a convertible investment is somewhat illusory.
Prepare For Later Rounds: Structure the friends and family investment so that it won’t cause problems with subsequent rounds. This requires attention to applicable securities laws. Even for small investments among friends, state and federal laws apply. Each state has its own “blue sky” laws covering investments sold to its residents; these can include, for example, requirements for filing certain forms in advance of making the pitch for funds. On the federal level, up to one million dollars can be raised with relatively few formalities. However, if the next investment round occurs within 6 months of the friends and family round, the federal rules may treat the two rounds as a single event. If the second round pushes the total above one million dollars, this may subject the friends and family round to documentation and filing requirements which can’t be met retroactively. While there are possible “work – arounds” when this situation arises, founders are better off raising enough in the friends and family round to ensure that the company won’t need another cash infusion for 6 months.
Securities law requirements are minimized if the investors are all “accredited” as defined in the federal rules. An accredited investor is one with a net worth of at least $1,000,000, or income of at least $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years, and who has a reasonable expectation of reaching the same income level in the current year. However, even accredited investors must be furnished with all “material” information about the company. “Material” is a technical legal term in this context, but the concept is easy for the entrepreneur to recognize: If a piece of information is something you’d want to know about, if you were considering whether to invest in the company, then it’s material and should be disclosed to the investors.
Special Rights: Depending on the sophistication of the company and the investors, the “friends and family” group may look for rights beyond just ownership of stock. Several things, though frequently sought by investors, should be resisted by the company. Avoid granting protections against dilution, and rights to block subsequent rounds unless the terms are to the liking of the friends and family investors. This level of control can seriously impede completing later rounds with professional investors. Conversely, some right to invest alongside subsequent investors is often given, and may be welcome by the company.
Conclusion: Company founders will have to deal with venture capital investors at board meetings, but will see their friends and family investors at holiday dinners and the country club. This means that clarity, simplicity, and clear (and complete!) documentation of the investment are essential.