This book overviews best practices for raising money from the first people you go to — your family, friends & founders. Dealing with money in personal relationships can get a bit tricky. This book will cover fundamental concepts, legal issues and material you’ll need. It will help prepare you for the difficult conversations and in some cases enable you to avoid them altogether.
Guide to Raising Capital from
Family, Friends & Founders
Capital With FFF
Bringing on a Co-Founder
Approaching Friends and Family
Pitching Your Business
Tax Issue: Gift Vs.
After The Loan
Startup Funding Timeline For High Growth Businesses
Startup funding for high growth businesses is acquired in multiple rounds throughout the business lifecycle. This funding cycle applies for most high growth businesses — including mobile, web, manufacturing and other tech industries, as well as consumer brands. This lifecycle is different for small businesses that only need enough funding to get the business off the ground.
High-growth startup funding is typically split into three rounds:
- Family, Friends and Founder (FFF) capital – ranging from $25,000 to $100,000
- Seed Capital from Angel Investors – ranging from $250,000 to $1,000,000
- Series A and Series B capital from Venture Capitalists – ranging from $3,000,000 to $10,000,000
The most important principle of startup fundraising that every entrepreneur needs to know regardless of the round of capital they are targeting is: raise enough capital to achieve a set of milestones that will allow the company to attract the next round of investment.
That is to say, FFF capital should be directed towards achieving the milestones that will attract seed investors. Likewise, seed capital should be used to achieve the milestones that will attract Series A capital.
As a startup with likely zero revenue, FFF do not expect the company to have achieved very many major milestones. Nonetheless, there are a few key milestones that you will need to achieve in order for them to sign over the check. These milestones include:
- Basic Business plan
- Personal investment
- Capitalization strategy and milestone timeline
- Market validation
- Prior success
This document is a guide for what you need to know about raising capital from FFF.
Using cash from FFF to start a business is quite common. Roughly half of startup entrepreneurs get financial support from friends and family members in beginning their venture. According the Global Entrepreneurship Monitor (Babson & London School of Business), $50 billion to $75 billion is invested annually by friends and family in U.S. startups. This is two to three times the amount of money invested annually by angel investors or venture capitalists, which invest approximately $20 billion per year in new businesses.
Bringing On A Co-Founder
While your friends and family present a great opportunity to raise capital to launch your business, you and your co-founders should plan on personally investing in the business. Investors at any stage like to see that you have committed personal funds in addition to sweat equity. First and foremost, if you aren’t willing to assume any of the risk, neither will investors. Secondly, by putting some skin in the game you are showing your commitment to the company.
Many entrepreneurs who have a great idea but no personal funds to invest in the business will seek out a co-founder prior to approaching their friends and family. This can be a great strategy if you are prepared to give up a large portion of equity. As they are founding and financing the organization, they are going to require a significant share of the company — and rightfully so.
Your co-founder will likely be in this for the long haul, so it is crucial you find the right person. Below are a few tips for finding the right startup co-founder for you and your business:
- Find someone with a complementary skill set to yours
- Find someone that is an expert in key areas of the business that you know nothing about
- Find someone that shares your values and work ethic
- Seek out references of people that have worked with a potential co-founder and do your due diligence
- Take your time to find the right person
- Know what you are looking forThe
Your friends and family are your most immediate source of funding beyond your own pockets. Chances are, they already know about your business idea and have seen your efforts to grow a company. Your friends and family have an interest in seeing you become successful and be happy in your career. Because of these relationships, they are happy to help you out in a way that makes sense for them financially. While you can structure your friends and family capital as loans that you plan on repaying, your friends and family can also be a source of gift money that they do not expect you to repay.
If you do set up a private loan agreement with a friend or family member, there are multiple advantages to the loan agreement that you cannot get from the bank. The first advantage is the moral support that your friend or family member will provide. They know you personally and are happy to watch you succeed, but they are also willing to help keep you motivated through the rough times your company will inevitably face. The second advantage is the flexibility in setting the terms of the loan. Your friend or family member lender can set an interest rate that is lower than that from a bank. You can also agree to a repayment schedule that fits you best. Since you are not dealing with a commercial institution, you are not limited to specific amounts to be repaid at specific points of time. In addition, while you must not take advantage of the generosity of your friend or family member’s loan, you do have a bit more wiggle room to alter the repayment calendar if necessary.
By taking the loan seriously and presenting your friends and family lenders with the legal documents of a legitimate business transaction, you open the discussion to the issues that are unique to mixing friends, family and money. Many issues can be avoided by identifying them and discussing them up front. Some of these issues include:
- Disappointing your friend or family member if your company fails: It is crucial to explain to them that failure is a possibility with any new business venture. You can offer reassurance by presenting the option to secure the loan. In the event that your company fails, with a secured loan he or she will be able to recoup their investment.
- Being unable to keep up with your repayment calendar: In this situation, you are best advised to be as proactive as possible with keeping your friend or family up to date on your financial situation. Letting them know as soon as you suspect that you may not make a repayment deadline, you can discuss an alternate pay arrangement that eases some of the strain on you.
- Getting into a “favor” war and feeling like you owe your lender something beyond repayment: To avoid a friend or family member using the fact that they loaned you money against you, make the transaction as formal as possible. If you offer an interest rate that is competitive with other investment opportunities, such as CDs, your lender will be assured your repayment with interest will fully reimburse them for their loan.
- Giving your lender the impression that they are actively involved in management: Communicate to your lender that your loan is purely a business transaction, not an opportunity to act as a quasi-employee of the company. Make sure all your discussions with the friend or family member avoid topics related to management, as you don’t want to give them the impression that you are seeking their advice.
Pitching Your Business
After you have narrowed down a list of ideal investors, you have probably realized that despite their ideal investor status, they may each necessitate a slightly different approach with your pitch. If it’s someone you are close with and see often, you could use a more informal approach when asking for an investment. If it’s a business contact or someone you don’t know as well, it would be appropriate to schedule a time to meet with them formally to discuss your business. When approaching this second group, a formal “elevator pitch” would be ideal. However, with your close friends and family this method is too formal; instead, utilize what is called a “kitchen table pitch.” Compared to an elevator pitch, the kitchen table pitch adapts to the pre-established relationship with the potential investor. It is delivered to ensure that if and when the discussion leads to investment, the relationship is still protected.
For potential investors who are very close to you, it is probably wise to find a way to get them to offer to help before you ask for money. If your potential investor knows you are excited about getting your business off the ground, they may naturally ask what they can do to support you. That would be a perfect segue into asking for their financial help. If that situation does not arise naturally, another method to initiate the conversation is to tell them how much money you need to get the business started and ask if they would be interested in investing a portion of it. Make sure to let them know why you have considered them for the opportunity so they see themselves as being able to provide value to you beyond the amount of the investment.
Make sure you give your potential investors some time to roll the idea around on their own before you assess their first reaction. Your potential investor is likely to need some time to review their finances and get outside opinions before they agree to go forward. Proactively address the concerns you can predict by telling them how their money is protected. But listen carefully to objections they have; some people simply will not be interested no matter how many assurances you give them.
Since friends and family are more likely to give you a gift of money than any other lender or investor, you must understand the tax consequences of a gift of money versus a loan of money. There is a specific gift tax and a limit on gifts that can be given.
Irs Limits On Gifts
The IRS presumes that money transfers between family members are gifts, and applies the gift tax to the transfer. Generally, the donor pays the tax on the gift. For 2017, the IRS provided a gift tax exclusion for up to $14,000 per donee. This means that a donor can gift up to $14,000 to you in a taxable year before they have to begin paying gift taxes. A presumption means that without any action on your part to prove otherwise, the IRS will treat the money as a gift and tax the lender on any amount above $14,000. You will protect yourself and your lender from this happening by proving that the transfer was indeed a loan. Having both the promissory note and proof of your repayments provides documentation for the IRS in the event of an audit. You want to avoid the IRS thinking the loan is a gift because not only does your lender have to pay a gift tax, but your lender will have the loan counted against their gift limit. If changes to the arrangement reflected in the promissory note occur, such as your lender occasionally gifting you a repayment, you should consider consulting your accountant or attorney.
If you and your lender agree to a loan without interest, the IRS will “impute” interest into the transaction. The difference between the loan without interest and the loan with interest will be counted as a gift from the lender to you. The rate the IRS uses to calculate the imputed interest is the Applicable Federal Rate, or AFR. If the imputed interest exceeds $14,000 in the taxable year, then your lender will have to pay a gift tax on the imputed interest. This is not likely to occur in practice, as a loan would have to be enormous to generate $14,000 of interest at the AFR.
Who To Approach
It’s time to generate a list of all your relatives, friends and acquaintances, no matter how distant. Consider everyone you can think of, as investments often come from unexpected sources. Your ideal friends and family investor has enough income where they can afford to lose their investment. They know you well and trust your leadership capabilities, and their investoment to you does not add any tension to your relationship. It is important to weigh which of these ideal characteristics is most important to you because it is rare but they will have all of these characteristics.
- Investor has experience running their own business: This is probably the least important characteristic in an investor, but a beneficial one nonetheless. These investors can provide advice in a way that is productive and useful because they have been there themselves.
- Investor has enough of an income to lose the investment: This characteristic is typically the most heavily weighted, and will help you begin eliminating contacts from your potential investor list. You may have lots of people who want to help and would be willing to lend to you, but you do not want to put anyone in a position where they risk falling into financial trouble as a result of you being unable to repay them.
- Investor knows your work ethic and trusts your judgment: This is crucial to find in an investor because it has a direct effect on how comfortable the person will feel when the money is out of his or her hands. This concern can be addressed by making the loan or investment formal with a promissory note and repayment schedule. It will assure the investor that they will recoup their money no matter what. But even with the paperwork protecting their money, a investor who is nervous about your money management is likely to pester you by questioning your decisions and commenting on your expenditures. You already have enough to worry about in this early stage of your business, and keeping an anxious investor off your back is a task you should not add to your responsibilities.
- Investor’s money will not cause friction in the relationship: Even if the investor trusts you and their money is protected with a legal agreement, if the investor’s spouse or siblings don’t get along with you, the investor is putting themselves in a tough situation. Avoid investors who are closely associated with someone who has a high potential to cause drama and stress in your relationships.
You know your options best. Use these characteristics as a guideline to narrow down your list of prospective investors to a list of ideal investors. By pre-screening your options using these criteria, you avoid adding additional stress to your capital search.
Debt versus Equity
Before you begin asking friends and family for an investment, it is imperative that you have put in the time necessary to write a business plan. Even when a business plan is not required, we believe it is an ethical obligation to go through the business planning process in order to protect investors’ money.
The process of preparing a business plan forces you to think about a whole array of issues that could arise in the course of starting your business. A savvy investor will ask for a business plan, but a less sophisticated investor would be well advised to see your thoughts in detail as presented in a business plan. By writing a business plan, you will have a better idea of how much capital you need to raise, how the it will be allocated and when you will be able to reasonably pay off your loans/investments.
Along with a business plan, it’s ideal to also present a formalized Funding Request and Use of Funds. It is better to put in the work ahead of time, determine the business’ needs in order to achieve the set milestones and with it how much money will be needed, as opposed to begin collecting without an exact plan as to how it will be used. The Use of Funds portion should be separated into categories such as: website development costs, office equipment and supplies, legal fees, consulting fees and operating expenses for X months until you anticipate the company breaking even.
In addition to listing specific expenses the investment will be used for, it is helpful to provide milestones the investment will allow the company to achieve.
- Developing the product (beta, minimum viable product, full launch, etc)
- Developing the team (co-founders, management time, key hires, advisory board, etc)
- Hiring a professional business plan consultant
- Setting up any outstanding legal or intellectual property requirements
- Acquiring first sale and market validationThe
It is likely that your friend or family member has taken out a loan himself or herself and is familiar with a promissory note. This familiarity serves a double purpose. It allows your lender to feel more comfortable investing in you and it will impress him or her with your professionalism. Putting the loan agreement into writing also solidifies your obligation to repay it. A promissory note clears up any confusion or misunderstanding that may arise due to the unsophisticated nature of the lender/borrower relationship. The more you emphasize the formality of the loan arrangement as a necessity of properly starting your new business, the less awkward it is to ask a friend or family member to put the agreement in writing.
Things you will want to include in a promissory note include:
- The names of both the borrower and the lender
- The location of the loan (for state tax purposes)
- The amount of money the lender is lending
- Whether or not the loan is secured with collateral
- The repayment schedule, both the amounts and dates of planned payments
- The consequences for missing a payment or defaulting on the loan
- Signatures of both lender and borrower
It is best to prepare a proposal for all of these terms for when you meet with your potential lender. Since the loan is private, all of the terms are negotiable. Be receptive to the wishes of your potential lender if you end up negotiating some of the terms, but be reasonable with what you are capable of paying at various intervals of time. Hopefully your business plan’s financial projections will help determine what kinds of terms are reasonable for your business.
Once you have set up the loan/equity arrangement, you have received the capital and work is underway with your business, you will want to communicate with your lenders periodically with updates on how your business is going. Whether you have good news or bad news to report, be honest with your investor about the progress of your business. You will have to decide, based on your relationship with the investor, what the best means of contact is to communicate your update. Some investors may prefer a phone call, others may prefer an in-person visit, and yet others may prefer something more formal, like a report.
Don’t forget to include your investors when you send out invitations to grand openings, they will want to see your business in action! You will also want to make sure that you focus these new funds on achieving the milestones that you laid out in your business plan. Hopefully these are in line with those investors care about and will look for when determining whether or not to give you your next round of seed capital.