How To Structure an investment deal with Friends & Family
How to structure friends and family investments? Startups often experience challenges in funding. It’s often difficult to secure funding from banks or venture capitalists or trade shares in the beginning.
The easiest way to finance startups is to get funds from friends and family. Friends and family act as a form of crowdfunding. They allow you to take a small amount of money from several family members and contacts. You’ll combine these funds for raising a larger overall sum.
As I share with members of Impakt Tribe, where we help from A to Z with everything related to fundraising, family and friends may even be willing to invest money in your business on low interest. Or interest-free basis compared to conventional investors.
Venture capitalists are a handful of companies and really require a big effort to secure any funding to bring your business to light.
The ease of raising funds from family and friends makes it the go solution for quick funding even before angel investors and venture capitalists.
Family and friend investments can help in meeting capital needs for early financing.
Friends and family investments usually range from €10,000 to €150,000 of their own personal money. That will depend on their loyalty and friendship & capital of course.
Once a business raises the requisite investment from close relationships, the business catapults in value. Then you can raise money from more conventional sources.
The close connection between the founders and the family and friends makes it easy to negotiate and obtain funding. As opposed to conventional sources that will require the business to meet stricter terms.
Still, you need to have a good structure to avoid problems in the future. There is a great temptation to find investment from friends without following the necessary formalities for more formal investments.
Properly document and structure the monies received from close family and friends so that it is easy to share profits and losses.
Good structuring will reduce any conflicts and create a good foundation for future investments. A well-structured investment makes it easier for you to go back to your friends and family when the business requires further investments for growth.
Proper structuring means drafting an investment agreement that explains bylaws, interests, profits, equity stakes, and other necessary details.
Advantages of Friends and Family Funding
There are many clear advantages of getting your funding from people who know. They know your potential and understand the probability of your business succeeding.
Friends and family lending can take place on a much larger scale and on a formal basis. Peer-to-peer websites, angel investments, venture capitalists, and bank loans often have stricter legal requirements. They have criteria that have to be met before the investments can be secured.
Friends and family investments are a much more flexible solution for your startup. Friends and family investments are easier to raise compared to all other investments.
It is possible to gain investment from friends and family even before the completion of the business plan. You’ll secure the investments from mutual trust rather than the validity of the idea on paper.
Conventional sources often require proof of the profitability of the business, sales, and other more technical factors. Those requirements make it hard for a business that requires funds to set up. That’s because it is hard to prove that a business concept would earn money without any real trial.
Family and friends already know the character and circumstances that you are bringing to the table. And may not require an extensively detailed business plan.
They offer investment on their knowledge of abilities. Hence one does not have to prove to the family member or friends what they are really capable of doing.
Due to their understanding of your circumstances and trust your family and friends maybe more patient in waiting for results too.
Demerits of Friends and Family Investments
It is true that family and friends can offer investments easily, at competitive interest rates, and can offer a more reasonable repayment plan. However, it is possible to run into a few problems along the way.
Money may change relationships between friends and family. Indebted family members may start exhorting power and control over the borrower.
The investor may start criticizing your business decisions and any business spending. The casual relationship between the family and friends can become strained in the shift of power.
A loved one may feel compelled to offer a business investment even when they do not foresee the success of the business. The discomfort can manifest during family meetings, dinners and holidays, and create lasting tensions.
Any small misunderstanding may damage relationships and even the prospects for the business. Family and friends’ loans lack some legal protections unless you take time to structure the family investments with your attorney.
When you work with banks and other venture capitalists, they set terms and conditions in advance before you can access the funding that protects both parties.
When there is no agreement a loved one may modify the terms of payment halfway through which may injure the success of the business. There can just be misunderstandings and separation in expectations. There may be no clear path to an amicable split.
Your Relationships Are At Stake Here
A business is a risk, and the returns are never guaranteed. Relatives and friends may push you forward and offer an investment amount they cannot afford to lose.
Taking such a risk can put both your investor and your business at risk. The investor may request their funds back during storms when the business has not grown enough to support the withdrawal of funds.
This sudden action can cripple the business and risk other people’s investments. Family and friends’ investments can cause a lot of pressure as they are your close circle.
Some family members may pressure you to succeed quickly, and that, coupled with constant contact with the same individuals, can lead to extreme pressure on the business.
There is often a chip on the shoulder to try and impress family members, to work hard, and keep the family proud. There is an incentive to pay back the money with or without interest.
However, if the business fails, you can lose more than just your personal savings, as you risk the savings of those closest to you. In contrast, angel and large investors have a large financial capacity that is able to absorb the shock from business losses.
You’ll allow friends and family to make investments in your business despite not being accredited to invest in businesses. They may not be under the same regulations as professional investors or in the case of public crowdfunding.
Still, it is a good idea to get your attorney involved in managing these investments. Investments, no matter how small, are regulated by local and national legislation.
Or there can be tax implications neither of you may be thinking about. An attorney can help avoid mistakes and future fights over cash and control.
Common Investment structuring
Structuring friends and family investments are not always easy if done well. Many firms structure family investments as equity splits.
The Investors receive stock issues or interest pledges in return for a loan for the business. There are other instruments such as convertible notes and preferred stocks as well.
The structuring is largely dependent on the type of funding that the business receives, and expects to use in the future. A family member could choose to make the investment as a business loan, which could be paid on interest.
Or equity funding where the family members become shareholders. The entrepreneur has to either take on debt or give an equity stake to the individuals as a way of showing appreciation for their support.
Since family and friend investments come into the business in their earliest stages it is difficult to know how much equity you can give to your family members at the start of the business.
It is possible to give too much, and therefore run a risk of losing control over the business, or hampering future fundraising needs.
Small loans are an easy way for small businesses to acquire funding from their dearest and nearest. These loans are often offered at the seed or pre-seed funding stages.
Businesses can use the funding from friends and family as a bailout option in case the business heads south in the short term.
Family and friends’ loans can have interest rates that may be lower than the market, or even zero, making it possible for businesses to succeed early on when business loans are expensive.
The loan agreement should be in writing so you can sort out disputes later and ensure that family members can keep their end of the deal.
The other option is to give family members and friends a share of ownership in the business through equity. A share in equity often gives them a say in the running of the business.
You have to give a lot of thought before dishing out equity, as equity means you are handing out the control of the company in order to secure some funding.
You have to ensure that you have adequate equity left over for yourself and future investors. The surplus equity could be used later when you need to secure funding from institutional investors, and for attracting great talent.
Equity investments are very strategic for the family and friends as the amount you owe the investors affects the future value of the business and exits.
Equity gives the shareholder a position and voice in the running of the business and the majority shareholder may take away your decision-making power in the business, or even fire you.
Even as you’re considering which family and friends to reach out to for funding, start planning the next steps. And, that includes doing your research on how to find investors for your startup.
Repayment Terms and Conditions
Written payments of terms and conditions are the most effective way of keeping the structure well set. You can have a lawyer help you to structure the repayment terms and conditions.
Writing out the terms and conditions remains essential, even when raising funds from friends and family that you trust the most. A friend and family investments agreement is an appropriate safeguard so that both parties can know the appropriate action to take in case of a dispute.
The most common dispute you’ll tackle is how to handle a situation where a company or the individual is unable to make repayments. Investors will often ask for a share in the event that the business makes a large profit.
You may also try to create safeguards to ensure the family and friends do not overstep into the business venture due to their investments.
Both personal and business relationships are unpredictable, and you never know when the relationships will hit rock bottom.
Well laid out repayment terms and conditions ensure that the two parties involved can remain professional and civil throughout the whole encounter.
The business should strive to keep their end of the bargain to ensure those family members who support your business receive their due at the right time.
Tips on Structuring Family or Friends Investments
Structuring the repayment terms is technical, and a good grip on the best practices can keep investments coming in and the relationships intact long after the investment.
You never know when you’ll be starting another business. You can use any of the following approaches to keep your relationship and business on the right footing.
Be clear about the expectations
Specify the amount of money you need, and the exact reason you need the funding
Detail the repayment period and how long you expect to make the payments
Spell out the rates from the onset such as the number of shares or profit they will receive when their interests are paid
Clarify whether or not the business investors will have any financial liabilities
Always draw up a formal agreement with the help of a lawyer
Analyze the reasons, benefits, or demerits of having funds from friends and family
Friends and family members can be a critical pillar for any business that needs to get quick funding at low-interest rates. These investors can be more patient and it can help them meet their goals too. But, do take the time to understand how to structure friends and family investments carefully.
Please let me know in the comment box below which of these tips you are going to use to find to set up your Friends & Family round?
Thank you in advance for sharing your thoughts.
Your biggest fan,
Jeroen van der Heide Co-founder & Ecopreneur
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