If you need financing to transform your nascent business idea into reality, you will likely not be eligible for a traditional bank loan if you have no business track record. Angel investors might be interested after you get your business off the ground, but will be hesitant to give you the seed capital to start from ground zero. Your best and, possibly, only option will be friends and family fundraising.
Raising startup capital from your family and friends, however, involves more than just having them write a check. The U.S. Securities and Exchange Commission (the “SEC”) and various state securities regulators might have bigger fish to fry than your small startup, but if you do not comply with the investment rules and regulations that the SEC and state regulators have established for business fundraising, you and your business might face thousands of dollars of fines and a possible shutdown prior to selling your first product.
With a friends and family round of financing, you can structure the investment as either a loan to your company or as consideration to purchase equity in your company.
If you decide to structure the investment as a loan, you will need a convertible note and related documents. In this case, the funds are initially borrowed, and often in lieu of later repayment, the investors have an option to convert the loan into equity at a later time. Many startups elect a convertible note structure so that they can push the valuation of the company to a later date. You will need to determine the trigger event that will convert the debt into equity, which is typically when the company raises it next round of equity round of financing. It will also be important to consider whether you will offer early investors a discount and/or a valuation cap.
In the event you choose to accept money in exchange for equity, you will need an agreement with the investors describing your business and its management structure, board of directors, managers, use of investment and specific representations and warranties, among other things. One of the most important terms to include is a list of risk factors that friends and family investors should consider before they invest in your company. The risk factors should apply to your specific business and the purpose is to let the investors know the risks they are taking on in exchange for the investment. Note, there are additional requirements for non-accredited investors, so you will need to know if your investors are accredited or non-accredited to ensure you are complying with the additional requirements.
Friends and family fundraising is a common and effective tool for new businesses when it is done right. It’s essential to know the pros and cons of accepting the friends and family investment in the form of a loan or for equity so that you can make an informed decision about what is right for your company.
Tricia Meyer is founder + managing attorney of Meyer Law, a woman-owned, forward-thinking boutique law firm specializing in helping entrepreneurs and technology companies from startups to fortune 500’s with corporate, contracts, employment and intellectual property matters in Technology, Telecom, FinTech, EdTech, AdTech, HealthTech, Internet of Things, Financial Services, Telecom, Social Media, Real Estate, Marketing, Advertising and Healthcare sectors. As an entrepreneur and a lawyer, Meyer has a unique perspective and is a mentor at tech incubators and accelerators across the United States. Learn more at www.MeetMeyerLaw.com and follow us on Twitter @Tricia_Meyer or @LoveYourLawFirm.