Hidden Costs Of An Informal Friends And Family Funding Round

Few founders understand the full implications and hidden costs of an informal friends and family round. You’ll likely approach these initial investors to supplement that bootstrapped capital you’re sinking into the new venture. Typically, at the pre-seed stage, when you’re exploring the concept.

Close to 38% of startup founders rely on friends and family (F&F) for funding. But though these are “informal” sources, you’ll treat them just as you would formal investors like angels and venture capitalists. Securing your personal relationships with people who believe in you is just one reason.

You’ll also consider issues such as their names appearing on the cap table and calculating returns. Don’t overlook how formal investors will view them when they do their due diligence before offering capital in later stages.

Even if the startup is small, seeking advice from an expert consultant is always advisable. The professional will guide you on the paperwork you need to draw up, complete with the dividends you’ll pay. Transparency is crucial at every stage of building the company, starting at stage one.

The fundamental practices and standard operating procedures you establish at this growth stage will shape the startup’s future stability. Here’s what you need to be aware of.

Understanding How the Informal Friends and Family Round Works

For the friends and family (F&F) round, you’ll approach close friends, family members, colleagues, acquaintances, and former employers. Basically, any individual with whom you have a trust-driven relationship. Your objective is to use the funds to develop a business plan and flesh out the idea.

The most crucial criterion here is to demonstrate that you have skin in the game. Not only have you invested sufficient personal funds, but you have also devoted your time to establishing the startup. Your investors need to see that this is no longer a side hustle, and you’re confident in your success.

As for funding amounts, expect to raise between $10K and $150K, though some founders raise up to $500K. They use the funds to develop the minimum viable product (MVP), research market demand, and achieve initial traction. These metrics are crucial for a successful seed funding round.

Risk of Strained Personal Relationships

Be mindful of the hidden costs of an informal friends and family funding round, which can affect your personal relationships. Loved ones are likely to invest in the startup not because they can evaluate its viability. But because they trust the entrepreneur.

Informal investors rarely have the expertise to validate the business idea or its profitability. Don’t overlook the fact that 90% of startups eventually fail. Failing to return principal or interest irreparably damages relationships, particularly when investors suffer significant financial losses personally.

The hidden costs for the founder include resentment, anger, and guilt that affect birthday, anniversary, and holiday celebrations. Whether formal or informal, entrepreneurs are accountable to their investors and must provide regular updates.

The personal nature of your relationships may lead them to be overly critical of your decisions. This can lead to bitterness on both sides, especially if returns are delayed or the startup fails. The reverse is also a downside.

Loved ones may place blind trust in the founder, even when they make glaringly obvious mistakes. On the other hand, formal investors offer expertise-driven advice and won’t hesitate to call out errors. This can be a significant advantage for entrepreneurs—particularly newbies in the industry.

Taking money from loved ones also means that you’ll take your work home every evening. You could encounter arguments around the dinner table instead of encouragement and enthusiasm.

Your solution is to be upfront with your informal investors about what they can expect. Ensure you state the expected return timeline. At the same time, underscore scenarios where the startup fails, and they lose money. Don’t gloss over the potential risks, but stress transparency and clarity.

Complexities in Valuing the Startup and Calculating Equity

The success of a funding round starts with an accurate valuation. However, unlike in a formal round, valuing a startup in its nascent stages can be complex. This complexity affects equity calculations and becomes one of the hidden costs of an informal friends and family funding round.

Typically, founders allocate between 5% and 20% of equity in a pre-seed round. However, experts recommend 10% to 15% equity to secure the cap table for future institutional investors in later-stage funding rounds. The question is—how would you value the startup?

Considering that the startup is pre-revenue, you’ll begin by adding up its assets, including the personal capital you’ve invested. Calculate the money, along with any personal guarantees and loans you’ve taken. Don’t overlook the salary you should be withdrawing, even if you aren’t paying yourself as yet.

With your consultant’s guidance, you could instead set up a vesting schedule that grants you equity to compensate for salary. The startup’s valuation should also include the intellectual property (IP) you’ve developed, including patents, blueprints, logos, and brand names.

If you’ve successfully created a minimum viable product (MVP) or working prototype, that raises the startup’s value. Also include customer reviews, early-adopter feedback, pre-release subscriptions, formal purchase contracts, and barriers to competitor entry—basically, proof of market validation.

You’ll treat this funding round exactly as you would any other formal round. This strategy enables you to calculate the equity you’ll give your informal investors. Remember that inaccurate valuation is a significant risk that can affect subsequent funding rounds.

If the startup pricing is too high, raising follow-on capital becomes challenging—you risk a down round. But if the pricing is too low, you’ll give away too much equity too soon. Be cautious about offering large equity stakes to informal investors to compensate for the risk.

Errors in Structuring the Cap Table

Errors in structuring the cap table can translate into long-term hidden costs of an informal friends and family funding round. Be wary of disputes that can arise between cofounders over capital raised from early F&F rounds. Statistics indicate that 65% of startups fail because of disputes.

Always structure informal investments with expert advice. A messy cap table with multiple small checks received from inexperienced shareholders is a major red flag for formal investors. They prefer to see a well-organized table with clearly defined ownership.

When evaluating a startup for funding, investors scrutinize the equity structure. How you handled these early investments reflects on your professionalism and business acumen. They are particularly wary of undocumented handshake deals you might have entered into.

These transactions can lead to legal complications, and many early-stage startups ultimately face lawsuits. Investors also have concerns about potential dilution for stakeholders, including small investors and founders.

Keep in mind that dilution and a diminishing ownership stake impact fundraising efforts. The threat of excessive dilution prompts investors to demand tougher terms and conditions to secure their investment. Issues of loss of control, voting rights, and a say in the company’s operations also arise.

Keep in mind that storytelling is everything in fundraising. In this regard, for a winning pitch deck to help you here, take a look at the template created by Peter Thiel, Silicon Valley legend (see it here), that I recently covered. Thiel was the first angel investor in Facebook with a $500K check that turned into more than $1 billion in cash.

Remember to unlock the pitch deck template that founders worldwide are using to raise millions below.

Uncertain Exit Horizons

If smaller, informal investors already hold large equity stakes of 20% to 40%, venture capitalists are hesitant to invest. The most fundamental concern is what happens when they exit the investment.

Typically, exits occur through a merger or acquisition when founders sell the company. Or, if it goes public with an Initial Public Offering (IPO). Informal investors may not follow the same exit horizons as formal investors, such as five to seven years.

Venture capitalists (VC) have longer investment horizons and typically hold their investments in line with the fund’s lifecycle. This cycle typically lasts about 10 years, though partners can extend it by about 2 years.

You can also expect them to support your company through follow-on rounds or bridge loans if necessary. F&F rounds may not have similar timelines. Personal commitments may prompt friends and family to request early repayment, and potentially destabilize the startup.

As part of the investment terms and conditions, you can commit to repayment when the company has the funds. Although F&F rounds typically don’t involve dividend payments, you could consider offering some amount of returns to cover risk.

Even if you’re running an informal funding round, you should know how to send a pitch deck to family and friends. Check out this video in which I have explained how it’s done.

Offering SAFEs to Early Investors

If you have chosen to issue SAFEs during the F&F round, this can have an impact on later rounds. Be wary of the hidden costs of an informal friends and family funding round arising from the terms and conditions.

SAFEs are Simple Agreements for Future Equity that entitle holders to convert their securities into equity. However, this conversion is subject to certain criteria that investors scrutinize carefully. For instance, SAFEs convert into equity when the company raises funding from institutional investors.

Although SAFEs don’t incur interest or have a maturity date, you should be cautious about the terms. A cap table with multiple SAFEs, each with different terms, is a red flag because SAFEs complicate the structure. Investors hesitate to offer capital because equity valuation and allocation are complex.

They may require a side letter that gives them additional benefits, such as information rights and board observer seats. Also expect to agree to pro rata rights, Most-Favored Nation (MFN) clause, cap resets, and optional conversion.

The bottom line is that before offering informal investors instruments to secure their investment, you’ll consider their long-term impact. Don’t overlook the hidden costs that influence future funding.

Legal and Regulatory Risks

Few founders account for the legal and regulatory risks of F&F rounds. Overlooking them can turn into another of the hidden costs of an informal friends and family funding round. Research into the local and state regulations that govern investments from non-accredited investors.

Taking capital from investors who don’t meet the high-net-worth requirements and lack adequate information about how securities work attracts penalties. You need to be cautious about proper documentation and clearly outlining the terms to avoid costly lawsuits.

Don’t rely on handshake deals; instead, put down every aspect in writing. Ensure all relevant parties sign the legally binding agreement. You’ll include information like:

• Are the funds a gift, a loan, or payment for equity?
• What are the rights investors get in exchange? Can they have a say in the company’s decisions or get access to information?
• What are the terms and deadline for repayment, if any?
• Can investors transfer their ownership stake to third parties? If so, what is the procedure?
• Can investors exit their investments and get their money back early?
• What happens to the ownership stake if the founder sells the company and liquidates its assets? Who gets what?
• What happens when the company raises funding from institutional investors? How will equity and voting rights be treated?
• Are there risks involved? What are the chances that the startup can fail? What are the failsafe measures to secure the startup?
• Can investors expect to receive interest, dividends, or any other returns? If so, what is the expected schedule?
• What if investors have questions about the company’s operations or the status of their investments?

Proper documentation has an added advantage. You’ll indicate to formal and informal investors that you’re building the company with a professional approach.

Minimizing the Hidden Costs of an Informal Friends and Family Funding Round

The key to raising capital from F&F sources or institutional investors is to treat every dollar with complete professionalism. You’ll approach investors with detailed documents outlining the business plan, equity structure, market size, competition, team, product, and expected revenue.

Formal or informal—your pitch deck should also include a slide with an exit strategy. Investors need to know when they can expect to see returns, particularly friends and family, as they aren’t diversifying their risk. They are investing all their personal funds into a single investment opportunity, your startup.

Treating that money with respect is how you’ll secure personal relationships, while also scaling the company. Maintain digital copies of all the documents and save them securely in a virtual data room.

Adopt a forward-thinking approach in every step you take. You’re setting your sights on a situation when the company is stable enough to raise further funding rounds from top investors. And possibly goes public with an Initial Public Offering (IPO).

The foundations you lay today will prove to be valuable assets when formal investors do their due diligence. Or, when potential buyers assess the company for a merger or acquisition.

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