A startup seeking to raise external funding will often look to familiar, supportive networks for capital first. A family and friends round is typically the first round of capital raising for a startup. This is when family and friends first invest in exchange for equity. However, many startups successfully self-fund or ‘bootstrap’ without taking on external funds. This article will explore how to approach a family and friends round, and the consequent task of securing external capital.
Steps in a Family and Friends Round
As the name ‘family and friends round’ suggests, this round of capital raising may be less formal for the founder in terms of the documentation. In more formal rounds, the founder may need to provide forecasting and demonstrate a proven concept.
A family and friends round may not require your startup to have developed a product or service already. This is unlike a seed round of funding, which typically involves angel investors (wealthy individuals) and early-stage venture capital firms. These investors are focused on this early stage of the lifecycle of a startup. Your family and friends may be content that you have a product or service idea that you believe in and wish to develop and be ready to take the leap to invest in your vision.
A family and friends round may appear less formal as the parties are familiar with each other. Even so, you should treat the round with caution, professionalism and with a long-term strategy in mind. Consider these steps as you approach your family and friends for investment:
1. Prepare Your Pitch
How will you communicate your startup’s product or service to a potential family or friend investor? Consider the expectations and sophistication of your investors and the best way to communicate your vision and story.
Your family and friends may appreciate a clear and succinct pitch deck that provides a clear overview. This would include the vision of your startup, your next milestone, and the desired investment. Alternatively, your family and friends may be content to hear your story, milestone and desired investment through an informal pitch or conversation. The right approach for your pitch will depend on your audience.
2. Decide On the Specific Details
Prior to approaching a pitch deck, investment conversation, or a ‘pitch’, consider key questions like:
- what is your next key milestone as a startup (this could be launching an app, reaching a particular amount of users or having your product stocked in particular retailers);
- how much money do you require to meet your next key milestone; and
- how much equity are you willing to give away to secure that investment?
It is vital that you, as the founder, decide on these terms. You need to know from the outset what you are and are not willing to negotiate to close the round.
3. Pitch and Negotiate
Once you have pitched to your investors, prepare to negotiate the terms. The length and complexity of negotiations depends on the sophistication and expectations of your investors.
A term sheet can be very helpful in focusing the parties on the key terms to settle. A term sheet is most commonly a non-binding document (although it can be binding). It sets out the exact details of the commercial transaction in capital raising. For example, how many shares are being issued (and what class of shares), what is the amount of capital and what is the date that completion is taking place? You may wish to have a term sheet drafted by lawyers who are trained to assist in these negotiations.
4. Formalise the Terms of Investment
The terms of investment are finalised in a binding share subscription agreement or letter. This is a critical step to the success of your family and friends round. If you have had a term sheet drafted, the share subscription agreement or letter may simply make those terms binding, or finalise a new set of terms. This will depend on your negotiations.
Having a share subscription agreement or letter drafted provides an authoritative copy of all the agreed terms between the parties. It specifies the exact investment and timelines to complete the deal.
5. Draft or Amend a Shareholders Agreement
Once your company has more than one shareholder and director, it is advisable to have a shareholders agreement drafted. This clearly sets out the rights and obligations of the directors and shareholders. An incoming investor may sign onto an existing shareholders agreement using a deed of accession. Alternatively, they will sign a new shareholders agreement if you are having a shareholders agreement drafted for the first time.
At the time when you are negotiating the terms of the particular investment, it is common to also negotiate the terms of the shareholders agreement. A shareholders agreement is an enduring document. It prescribes the approach by which directors and shareholders manage key matters, including:
- issuing new shares;
- appointing new directors;
- resolving disputes; and
- potential exit events.
6. Complete the Transaction
To finalise the investment transaction, the startup issues share certificates to the incoming investors. This provides proof of ownership of shares in exchange for money that the investor transfers to the company. Simultaneously, the parties sign any company documents, such as the shareholders agreement.
The company has additional secretarial duties to perform to finalise the investment. Notably, the company must update the Australian Security and Investments Commission’s records to reflect the change in shareholding within 28 days. The company must also update its members register to show the change in shareholding.
The Importance of Your First Round of External Capital
Your family and friends round can offer a timely source of capital to your growing business. However, this round may also cause future issues for your company, particularly if you intend to raise future rounds of capital and bring other investors on board. Two examples of potential pitfalls to consider are equity and management.
Whenever you consider giving away equity in your company in exchange for capital, you should be careful and considered. You should ensure that you structure your family and friends round with a commercial and strategic mindset.
For example, if you choose to raise future rounds of capital, a family and friends round may deter an investor. The investor may not like that you offered too much equity to a family or friend investor in an early round, leaving a smaller piece of the pie for future investors.
There is some agreement among venture capital firms and professional investors that you should give away a maximum of 20% of your company in a seed round (the round that typically follows a family and friends round). However, the exact percentage that is right for your company in a particular round will depend upon a number of factors. These include:
- how desperately you require capital;
- how much capital is being invested; and
- how much the founders have already invested.
It may also deter an investor that an unsophisticated (albeit, supportive) family member or friend holds a board seat. The challenge is that they would be involved in the day-to-day decision making and longer-term strategy of your company.
Carefully consider who you appoint as a director to your board, keeping in mind that a director’s purpose in your company is to:
- act with care and competence in managing the business to the degree that a reasonable person would do if they were in the same position;
- exercise their powers and duties in good faith and always in the best interests of the company; and
- not use their position as a director to gain an advantage for themselves to the detriment of the company (among other duties).
This is not an exhaustive list of issues with a family and friends round. However, it demonstrates the longer-term impact of an initial round of capital raising on your future opportunities. From your family and friends’ perspectives, it is also important that the family and friends round is fair and that you clearly explain the risks of investment. There is no certain investment and that is particularly salient in the growth-focused, and, sometimes, volatile environment of startups.
A family and friends round is the name typically given to the first round of external capital raising undertaken by a company, among their family and friends networks. Although you are likely to be familiar with the investors in a family and friends round, the investment should still be treated by both parties as a commercial transaction.
As a founder, you should ensure that you have the proper documentation in place to give certainty to both your company and investors about the agreed terms and when the transaction will be completed. If you have any questions about protecting your startup and your family and friends, get in touch with LegalVision’s startup lawyers on1300 544 755 or fill out the form on this page.
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