These financing rounds work in the following way: a specific individual invests a certain amount. Suppose the business reaches (or exceeds) a particular milestone, the lending party deposits another predetermined amount of financing. This is also a frequent strategy for some later-stage investors.
Typically you will go out to friends and family once you have a great presentation that perhaps you created after looking at great pitch decks on the internet from other startups.
Get a Lawyer
If you haven’t already done so, now is the time to hire an attorney to draft the agreements with any friends or family members who are willing to help, even if simple loans are the option you’re going for.
It’s vital to employ someone who has experience working with many startups because it’s all too usual for a well-intentioned (but inexperienced) attorney to cause problems down the line if the initial structure and setup aren’t done correctly.
Also, while it is feasible to find attorneys that work for stock in startups, it is not always encouraged, because having a neutral party is critical for crucial advising work (although it may be appropriate for more duties like contracts and terms/conditions agreements).
A deferral arrangement is more frequent, allowing you to pay off your balance once you’ve raised a significant amount of money. However, this is a straightforward way to build up payables. Beware of mounting legal expenses, and frequently talk with your attorney about budget expectations before work begins.
Be Specific About What You Will Do With the Money
While having a complete pitch deck, executive summary, and financial model to present with your friends and family isn’t necessary at this time, the more you have in place, the better. If you think about it, an investor should know what they’re getting themselves into and that the item they’re investing in will have market value in the future and potential to generate a profit.
As you raise later rounds, you’ll need to get into the habit of having updated paperwork for your investors, but for now, focus on a precise plan for what you want to accomplish in terms of your product, marketing, sales, and team growth.
Convertible Note Options if Friends or Family Want Stock in Your Startup
Convertible notes are a simple financial instrument with the ability to convert into stock later, comparable to a regular loan (term, interest, etc.). Convertible noteholders are issued shares according to the arrangement’s terms when a funding round establishes a startup valuation. This is often done at the Series A level.
Your attorney will likely advise you that it’s generally a good idea to propose going this route if your friends or family are throwing money in, and the standards of an accredited investor.
Be Cautious with Your Cap Table
One of the most typical early-stage errors is having too many full-fledged co-founders (those who plan to work full-time for the startup) and giving away too much stock. You should review all of this with your startup attorney, but in general, you want two or three people to control the great majority of your startup’s stock.
If you’re bringing on partners for equity splits, be wary of giving away too much to what are essentially service providers who act as early co-founders.
What is a Cap Table?
A capitalization table, sometimes called a cap table, is a spreadsheet or table that displays a company’s stock capitalization. Startups and early-stage companies most typically use a capitalization table, but any company can use it. The capitalization table, in general, is a detailed analysis of a company’s shareholders’ equity.
In the early phases of a startup, cap tables are generated initially, before other company documentation. Cap tables become more complicated after a few financing rounds and layout of the owners of stock and shares.
After Series A, a good rule of thumb is that the founders should hold at least 50% of the startup. From there, you can navigate your way back and forth.
The following are features of a suitable cap table:
- The CEO/Founder owns the majority share of the startup.
- As much as possible is owned by the founders.
- There is now an ESOP (employee stock ownership program) in place.
- There haven’t been any previous rounds where investors, including family and friends, bought more than 30% of the startup.
- Outside investors should own less than 50% of a company.
- There are no investors on the cap table with a poor reputation or who could cause a future conflict.
- There are no advisors, or other investors awarded a disproportionately large number of shares.
The majority of rounds are between 10% and 25%, but it isn’t good if you’ve given up 50% or more in a single round.
Founders and potential investors, including friends and family, might try a recap with existing investors, threatening that there won’t be any additional rounds if there isn’t a recap.
Your Friends and Family Money can be Part of Your Success
We can safely say that most startups fail between the original concept and the first few weeks after the product launches due to a lack of customer/user engagement and investor/team motivation to persevere.
On the other hand, founders have an excellent opportunity to boost their chances of developing a successful company with the appropriate combination of a strong team, original service providers, and friends and family money invested wisely.