What is family and friends funding?
Starting a business can potentially require having or raising a lot of money. Whether it's designing prototypes of a product, renting a space for an office, or buying the technology to run it, there are a lot of costs that you incur before you even officially open up shop. Quite often, when looking at new businesses to invest in, banks and other investors might not want to risk investing in a brand-new company. This is where family and friends funding can be very beneficial and can make sure that you get your business off the ground without as much strain on your own bank account. In general, friends and family funding is a type of crowdfunding where you raise small amounts of money from family members or friends to raise a more significant total amount. Family and friends funding gives the investor peace of mind because they are investing in someone that they have a personal relationship with, so they are confident in the person and the business that they are investing in.
What are the different kinds of family and friends funding?
There are three different kinds of friends and family investments: gifts, loans, or equity investments. Regardless of which type of investment is obtained, it is essential that each one is recorded in writing and memorialized, something that a startup lawyer can help you with.
- Gift: A gift is a sum of money that you, as the owner, don't have to pay back to the investor. While this type of investment sounds excellent, you likely will not raise as much from a gift as you would if you offered a return on the money given. Even though it seems innocent and friendly, the most critical aspect of a gift is memorializing the agreement and getting a signed document stating that the money was a gift. This protects you from a miscommunication between you and the investor that could result in the gift turning into a loan.
- Loan: A loan is often the ideal method of investing for everyone involved. There are set repayment terms with a loan, meaning that you get the money needed for your business and the investors know that they will get their money back in a specified time frame and at a fixed interest rate. With loans, a promissory note must be drafted to set out the terms of the loan so everyone involved knows what to expect. Again, this is something that a startup lawyer can help you to protect you should anything arise concerning the loan.
- Equity Investment: An equity investment differs from any other type of friends and family investment because you are giving the investor an ownership stake in the company, making them into a business partner rather than just an investor. The benefit to this arrangement is that you do not have to pay them their money back or any interest until the business starts to profit or decide to cash out. With the high stakes of bringing on a new business partner and changing the company's ownership structure, it is vital to have a startup or business lawyer involved to protect everyone's interests.
No matter what kind of family and friends funding you decide to raise through, it is always crucial to consult with an experienced startup lawyer to ensure you protect your rights and your interests.
How does family and friends funding work?
Family and friends funding is less sophisticated and formal than investments from banks and other professional investors. However, family and friends funding still requires some degree of formality in order to make everyone feel comfortable and confident in the investment. There are many different ways to approach family and friends funding depending on who you are approaching, but there are a few constants.
The first step should always be to prepare for the conversation by compiling information about the company and what their investment will go toward. The next step is simply to ask properly. When asking for an investment, it is crucial that you show passion for the idea and the future of the business. You should also show the progress you have made with the company since inception and that you have been investing your own money and asking for a minimum investment rather than a maximum.
Although family and friends funding is less formal than bank investments, it still requires some thorough documentation, such as documents acknowledging the risk, a promissory note detailing repayment, or a partnership agreement.
When asking a family member or friend to invest in your business, it is essential to treat it as you would a bank or other professional investment. Therefore, you should prepare an “elevator pitch” to explain your business plan, the risks, and what the money will be used for. Although you don't need to present all of your print materials, such as charts and financial statements, you must be upfront with your approach and be prepared to present these materials if asked.
What are the pros of raising capital from family and friends?
The biggest pro of raising capital from family and friends is that this is often the best chance of raising money to get your business started and off the ground. In addition, your friends and family are in a better position than outside investors because they know you, trust you, and have personally seen you put a lot of your own time and money into this business, making them more likely to invest in you and your business.
Another benefit of family and friends funding is that it can put you one step closer to securing much more significant investments from outside, professional investors. If you can show that you have a network of invested people in the business and believe in its plan and model, rather than just yourself, this shows professional investors that you are taking this business seriously and putting in the necessary work.
What are the cons of raising capital from family and friends?
One of the cons of raising capital from family and friends is the added risk of losing friends or straining relationships with family members or friends. If your family or friend investors are unclear on the repayment structure for their investment or they think you should be doing something different with the business itself, this can put a strain on the relationship.
One way to fix this is to be open and honest with the potential investor by being upfront about all of the potential risks of investing in a new business. Explain what the investment is going towards, your plans for the company's future, and create a written agreement for the rules and terms of the investment.
Another downside of friends and family funding is that it puts added pressure on the founder to keep the business running and thriving. When the money comes from the people closest to you, you feel more responsible for ensuring that each investor receives a positive return on their investment or the money they loaned. If the business fails, you would not only be risking your personal savings and anything you invested into the company; you would also be risking money from those closest to you and who had great trust and belief in you and your idea.
Similarities between family and friends funding and other forms of financing:
There are many different ways to obtain funding and investments for a startup.
Peer-to-peer investments are a form of funding where the potential borrowers are connected directly with individuals willing to finance loans and invest in startups. With peer-to-peer investing, borrowers apply for loans on lending platforms and cut out the banks and any other middlemen. This gives borrowers faster access to funds and investments while also providing the investors potential for greater return.
An angel investor is a high-net-worth individual that provides investment and funding, usually in return for ownership equity in the company. Angel investments often offer more favorable terms than other forms of investment because the investor is more interested in getting the startup off the ground rather than looking for profit from the business.
Crowdfunding is a method that allows a company to ask a large number of investors to each give a small amount to the startup, typically receiving equity shares in the company. From crowdfunding, lenders usually receive a higher interest rate than other types of funding. Still, they typically spread a large amount of money in small amounts to a large number of investments or loans.
While each of these investment types has its own specifications and differences, each one has the potential to be a friends and family investment due to the shared features and commonalities. Friends and family investments are a form of peer-to-peer investments, angel investments, and crowdfunding. Like peer-to-peer investments, friends and family funding connects the borrowers directly with the individuals willing to invest. Just like angel investments, a friend or family member who is willing to invest in the company could be a high-net-worth individual seeking ownership equity in the company.
Finally, just like crowdfunding, friends and family investments involve asking many individuals, friends, and family in this instance to give a small amount to the company to raise a more considerable total amount.
What are the typical repayment terms for friends and family investments?
When accepting investments from anyone, whether family and friends or a professional investor, it is vital to have an agreement drawn up with the repayment terms and any other important provisions for that specific investment agreement. There are options for every business owner when receiving funding from friends and family members about repayment terms, such as consulting with an attorney, considering the IRS federal interest rate, or negotiating the repayment terms with each individual investor.
The IRS requires lenders to adhere to the applicable federal interest rate and considers any loan made to have the interest rate as a minimum for tax purposes. So, if a loan is made interest-free, then the lender will carry the tax cost equal to the rate. Of course, for any investment from a family member or friend, the rate, term, and any other repayment terms will depend on the investment, the business, the owner, the investor, and many other factors specific to each investment.
For the term of the friends and family investment, it is essential to consider the timing requirements for the purpose of the loan. When you go to friends or family members for funding, it is likely that you are not looking for long-term investments to fund significant business decisions. Instead, it is more common to be obtaining enough funding to get out of the prototype stage, obtain patents, or any other short-term goals. Because of this, the term for repayment of the investment depends on the purpose and how long it will take to complete that purpose.
For the rate, this depends on the interest rates at the time of the investment and the potential for profit that the investment provides for the business. Rates are a lot trickier to negotiate because the business owner and the investor likely do not have enough information or know enough about typical rates to have a complete negotiation. If you or the investor feel uncomfortable negotiating any aspect of the repayment terms, it is crucial to contact a startup lawyer to help you determine the best structure for any investment.
What are important provisions to include in any contract with family and friends?
The obvious essential provisions to include in any contract for investments from friends and family are the rate, term, amount, and repayment provisions for the investment. In addition, it is vital to create a promissory note for a loan investment or a purchase agreement for an equity investment.
It is critical to structure the contract and expressly state in the contract what type of investment it is so that every person involved knows exactly what to expect from the investment. It is also important to include a business plan for the investment with details such as the risks associated with the investment and the business, a Strengths, Weaknesses, Opportunities, and Threats (or SWOT) analysis, and any information relevant to the product, the purpose of the investment, and due diligence that relates to the business
When creating the contract for investment from family and friends, it is essential to include information that memorializes the relationship and any negotiations that occurred.
How can a startup lawyer help me when raising investments from friends and family?
A startup lawyer can help you with everything along the way to raising investments from friends and family, from planning out your pitch to completing the contracts detailing the agreement and the investment. When dealing with negotiations and structuring repayment provisions and terms, it is a great help to have a startup lawyer who knows the requirements and the norms among other investments to ensure that the deal is beneficial to everyone involved.
Contact Newburn Law now to learn about how we can help you raise through friends and family investments while ensuring you make the best decisions for you and your business.