Blog + News
Startup Funding: Raising Early-Stage Capital from Your Personal Network Part 1.
Part 1 - Benefits and Considerations
The number one challenge for startups is money.
It’s expected for startups to operate on a loss, especially in their early years, but too much loss can lead to outright failure. It’s a delicate balancing act – spending enough money to grow your business while maintaining enough funds to remain financially solvent.
Therefore, start-up founders with a strong personal network of friends, family, and former colleagues may consider leveraging this group first when raising funding.
According to a 2014 Kauffman Foundation report, using an Inc. 500 study, 20.9% of startup survey respondents made use of funds from family members, and another 7.5% from close friends. Six years later, in 2020, Clutch, a B2B ratings company reported that 19% of founders made use of friends and family, at least for follow-up funding.
This percentage may seem high considering how many versions of the old saying, “don’t mix friends and money,” exist. In fact, even the Clutch survey goes on to say that 64% of founders are uncomfortable with asking friends or family for business loans.
So, let’s outline the best ways to navigate these tricky waters, specifically the associated legal considerations entrepreneurs must manage.
Leaning on established trusting relationships
There are undeniable benefits to raising money from within your circle. In the competitive world of startups, it can be hard to stand out, especially if you’re new to the game and don’t have the history to back up your entrepreneurial endeavors.
Friends and family are generally more receptive than strangers. They’re willing to hear your pitch and genuinely wish you success—that often translates to giving you the first chance.
Friends and family also tend to be more flexible than professional investors.
Freedom and Flexibility
While it’s standard for established investors and firms to ask for guarantees, audits, and strict contract stipulations, less experienced investors may not want to deal with that hassle and can be more willing to let things slide. Therefore, you can get by with fewer qualifications and gain more freedom in operating your business.
Personal connections can also be more flexible when it comes to compensation. This is especially true for close family members, who are personally invested in your success.
Unlike independent investors who tend to make strict demands, friends and family may prefer lenient repayment plans, no or low-interest rates, and perhaps even gift money without any strings attached.
Legal requirements for any investor
The Securities and Exchange Commission (SEC) enforces legal requirements for investing, which the average person might not meet. In the case of startups, entrepreneurs must be aware of Regulation D requirements.
Regulation D says that a risky investment, such as a startup, cannot be offered to the public. Rather, the investment can only be offered to “qualified investors,” who are people who will not go homeless, go on public help, or become financially ruined if the investment fails.
As of this writing, “qualified investors” include individuals that make $250,000 a year if single for the past three years, or $350,000 a year as a married couple. It also includes individuals who are worth $1,000,000, not counting the value of their primary residence.
Creating a roadmap and disclaimer for investors
Startups can file for exemption from Regulation D requirements, which allows otherwise non-qualified individuals to invest.
For startups to be exempt, they’re required to give a much larger disclosure document that clearly states the risks involved. This is often done in the form of a Private Placement Memorandum (PPM).
A PPM is a large document that essentially is a detailed business plan and legal warnings around all the risks of the startup, including clauses that repeatedly warn the investor that they might lose all their money. It serves as a simultaneous business roadmap and disclaimer to investors.
In addition, a PPM can serve as a legal trail, so when you start working with professional financiers with compliance concerns, there is less retroactive paperwork to deal with.
Recognizing the limits of friends and family funding
Raising money from friends and family can truly be beneficial in the early stages of entrepreneurship, when you don’t have the history or experience in the startup world to back yourself up.
But after a certain point, you need to seek the discipline of obtaining smart money, that is money from an experienced startup financier able to help create deals, give advice, and supply contacts in the actual operation of the company.
In addition, friends and family fundraising rounds typically do not provide the large sums of money needed for long-term startup growth. So for Series Seed and especially Series A fundraising rounds and beyond, you should look for professional investors.
Summary of wisdom
- For your very early capital, you can turn to friends and family, provided they understand they can lose their money just like any other investment. Note that finance documents can be overwhelming to non-professional readers, consider walking through the document “in plain English” if working with your friends and family.
- You may need to be the one to pump the brakes if you perceive that friends and family are providing money that they really can’t afford to lose. Consider getting a private placement memorandum (PPM) to ensure proper disclosure to your network and avoid retroactive paperwork when you start working with professional financiers.
- When you need serious amounts of capital that come with governance rights, skip friends and family and look for professional financiers who know your business and actively take steps to make sure the company succeeds.
- Fundraising from your immediate network should only be a launching point for greater success. To become a successful entrepreneur, you must branch out from your comfort zone.
Now that you’ve considered the benefits and legal considerations of fundraising from friends and family, stay tuned for Part 2 of the series, which will detail the common pitfalls of involving personal connections into your business.
INDIVIDUAL ARTICLE DISCLAIMER: