Should You Raise Friends & Family Funding For Your Startup?

Friends & family funding is often the first source of external funding for an early-stage startup that need capital, before it can turn to angels or VCs, if not the only one. Indeed, 38% of US startups raised friends & family money vs. only 0.9% that successfully raised VC money.

Although a very attractive source of funding because of its flexibility, friends & family money isn’t straightforward either.

What exactly is friends & family and how is different vs. angel money? What are the pros and cons of raising friends & family funding for a startup? How to structure friends & family instruments?

In this article we’ll go though everything you should know about raising friends & family funding for your startup, and whether this is for you. We’ll cover:

What (Exactly) Is Friends & Family Funding?

Most startups need external financing to fund growth. Yet, the more early-stage a startup is, the more difficult it is to get funding.

Indeed, early-stage startups often don’t have yet a MVP, nor a complete founding team, customers, revenue. Sometimes, founders only have an idea when they raise money. As such, friends & family is a form of pre-seed or seed startup financing.

This is where friends & family comes into play: in their early days, founders often get financing from their own network of friends and family. These are individuals that generally invest anywhere from $5,000 to $50,000 from their own personal finances.

How is friends & family different vs. angel money?

Because they’re both a form of early-stage financing, friends & family and angel funding can easily be misunderstood. Here is a comparison table so you understand their key differences:

Friends & familyAngel investors
Type of investorPrivate individual, usually a personal connection (either a friend of family member). Not necessarily a high-net-worth individual Private high-net-worth individual. An angel isn’t necessarily a personal connection to the founders
Average investment size$25,000$75,000
Funding roundPre-seed (or less often, seed)Often seed but can also participate at future rounds (Series A or higher)
Startup valuationTypically < $1 million Typically > $1 million
Other benefitsNone (friends & family is very often only a source of funding)Due to their experience and/or own network, angel investors can bring substantial benefits to early-stage startups, other than money. They can advise on business and/or strategic matters, open doors to their own network (investors and/or customers), etc.

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Why is friends & family so attractive for founders?

For founders, friends & family is a very attractive source of capital. Indeed, because it is mostly based on trust between friend relationships and loved ones, it is often very flexible and inexpensive.

Indeed, it isn’t uncommon to see startups get no-interest business loans from friends & family.

Yet, because friends & family isn’t a standardized form of financing with clear legal documentation, it’s often misunderstood and can also lead to significant problems down the road.

Friends & Family: Pros And Cons

As any other form of financing, friends & family come with their own pros and cons for startups.

Pro 1: It’s often the only source of financing available

Beyond founders’ own pocket money, there is often no possibility to get angel investors. For a complete checklist of what you need to raise seed money from angel investors and VC funds, read our article here.

So if you can’t show any of these elements on our seed funding checklist, friends and family might be the only option for your startup.

Pro 2: Access to funds is immediate

Because you’re raising money using established trust from people who already know you, and because friends & family aren’t necessarily experienced investors, there’s little due diligence (if any).

Also, friends & family typically comes with little legal documentation. Money is sometimes disbursed to founders without any form of legal contract (yet you shouldn’t do this – see below).

Therefore, little (or no) due diligence, and a light legal documentation means shorter time to access funds. You can easily get money within a few days, as long as you can convince your friends and loved ones you’ll repay them in the future

Pro 3: Terms are very flexible

For the same reason of trust we discussed above, friends & family typically are investments which are fully customized, and terms are agreed on a case-by-case basis.

Therefore, there are plenty of choices to choose from: business loan (with or without interest and/or maturity), equity, convertible debt, warrant, etc.

Yet, because they’re often not experienced investors, friends & family investments unfortunately aren’t well defined either. This can create problems as we will see below. To avoid these problems, we strongly recommend reading up on term sheets and their key terms. Also, make sure to hire a lawyer to review your contract, as simple as it may be.

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Pro 4: It can be pretty inexpensive

If it is structured as a debt investment (like a loan), friends & family investments can be very cheap for founders.

Let’s assume your startup raises $50,000 funding from friends & family as a loan with 20% accruing interest. This means you’ll have to repay their investment in the future: $60,000 in one year, or $72,000 in 2 years, and so on. This is very attractive for 2 reasons:

  • You don’t lose any ownership. Selling equity early stage is always a big problem, as valuation is difficult to assess to know how much equity percentage you should leave friends & family. See more on that below. Instead, if you raise friends & family as a loan, you’ll keep 100% of your business and the returns that come with it when you exit
  • You keep all the upside. This follows what we just discussed: equity investors enjoy upside potential (the value of their investment to go up). Instead, debt investors have downside protection: they’re the first in the line to be repaid. The problem for debt investors that invest in early stage startups is that, in case of a bankruptcy, they almost never get repaid (unlike mature companies, startups are cash poor). This is bad for debt investors, but great for founders. Think of it that way: assume you raise $50k as a business loan when your business is worth maybe $500k, that’d be 10% if you raised equity right? With debt instead, assuming you repay the loan in 2 year, using your seed funding then at a $3 million valuation, you’ll only have to repay $72k, which otherwise would have costed you $300k (10% of the $3 million)

Con 1: It can seriously damage relationships

Friends and family members are your inner circle. Therefore, things can quickly get messy when money is involved. This is especially true when the terms aren’t clearly defined upfront (more on that below).

Con 2: It can easily lead to difficult situations if not structured correctly at the outset

As we explained earlier, friends & family is the most flexible form of funding a startup can get.

It’s fully customised based on what you need as a founder, and what the investor is willing to agree to. Trust is generally more the bond than the contract itself.

Yet, this doesn’t mean you should overlook legal documentation either. Problem may arise for a number of reasons.

What would you do if you sold a 15% equity for $100k, yet 12 months down the line your business is so successful that it’s now worth $5 million? Your friend made a 7.5x return over a year, not bad. You, comparison, made a terrible mistake and misjudged your valuation back then.

Another example:

Let’s assume you agreed to a $100k convertible loan with a 1 year maturity. At maturity, you haven’t managed to raise equity yet, so your friend (or family member asks you to repay the $100k). What do you do if you don’t have this $100k? This can easily to a bankruptcy, damaged relationship, or both.

Con 2: It can be very expensive if not done correctly

Pricing an equity investment for an early stage startup is challenging, as we saw in our 7.5x return example above.

It’s even more difficult that you’re asking a friend to accept a relatively low percentage of equity whilst your business isn’t even generating revenue yet, nor doesn’t have a MVP.

That’s why many founders accept ridiculously attractive terms in their early days. This is a problem as you’ve already given away too much too early which can be a turn off for future, more experienced investors. Also, as a founder, you’ll likely lose control of your business sooner.

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How To Structure Friends & Family Instruments?

As we saw earlier, friends and family are very flexible when it comes to the type of instruments you can choose and the terms you can agree to.

Yet, before you go ahead with an investment, make sure to do 2 things:

  • Choose one financial instrument that suits you best
  • Document everything in a custom legal agreement

Different types of friends & family instruments

Friends & family investments can be structured either as debt, convertible debt, or equity investments. Each have their own pros and cons. For more details on what these are, read our articles below:

Remember that raising equity at the outset will require you to agree on a valuation to know how much ownership you will have to give away. Before you agree to anything, you’ll have to understand how cap tables work. And to avoid suffering from excessive equity dilution, read our article here.

Document everything

Whatever instrument you choose to structure your friends & family investment, you’ll need to document everything as part of a proper legal agreement.

The agreement content and structure will depend on the type of instrument you would have chosen. For example, convertible notes can be as short as 2 pages.

To know what you should include in your legal agreement, use financial terms and clauses that are typically included in term sheets by experienced investors. See our article on term sheets (+ 2 free templates).

When it comes to legal documentation, for those who actually prepare legal contracts, most founders make the same mistakes. Often, legal agreements limit themselves to the amount of investment and broad definitions.

Instead, we strongly recommend you include clauses that will protect you as a founder in case things don’t go as planned. Governance, control, exit and liquidation clauses are some examples of terms you want to define upfront, whatever amount you’re raising.

Setting up in a contract what should happen in hypothetical situations (such as the sale of the company or even bankruptcy) will ensure there is no misunderstanding if these events happen. This will not only save your relationship with your friend or family member, but also avoid potential future investors to back away from the deal. Indeed, angels and VC funds are very reluctant to invest in startups where previous investors’ terms have been loosely defined, or worse, haven’t been defined at all.

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