Raising Money for Your Business: The Friends and Family Round

You came up with a great new business idea, set up a corporation for yourself, and have launched a great website. You’re working hard to develop your product or app, and have a solid business plan for going to market.

Now, you just need something almost all new businesses sorely lack – money!

“Bootstrapping” is the term given to founders who spend their own money to develop their idea and grow the business before raising an outside round of capital. Bootstrapping may mean you work a day job and build your business at night, or you may take out a personal loan, perhaps a home equity line of credit, to secure funds for the new venture.

However, many entrepreneurs do not have the financial resources or assets to adequately bootstrap their new venture, or they simply do not want to take on so much personal financial risk.

Thus, a common place for an entrepreneur to start is to ask close friends and family for a loan or other investment (for example, offering stock in the corporation or a promissory note that will convert to stock when the company has value). In the start-up world, this is called “Friends and Family” financing or the “Friends and Family Round”.

Friends and Family Rounds can happen quickly and to the inexperienced entrepreneur, may appear to be the easiest and best way to raise money. Who can deny the potential to raise loads of cash by asking people who already have love and respect for you?

A properly-handled Friends and Family Round usually raises $25,000 to $150,000 for the venture but, of course, the amount raised depends a lot on who your friends and family are.

Unfortunately, many entrepreneurs do not approach their Friends and Family Round with the appropriate level of caution as far as the legal risks that may be involved. Often the thought is that since there is already a lot of trust and goodwill between you and these investors, preparing a lot of legal documents is unnecessary or not worth the cost.

However, a poorly planned or sloppily executed Friends and Family Round can have disastrous consequences for the business.  You could be hit with criminal investigations by government regulators resulting in fines, penalties or rescission (undoing or cancelling the securities offering), or lawsuits from your investors who say you misrepresented the ask for money or misused the funds they gave to you.

These issues can destroy your venture and your ability to raise money ever again, not to mention permanently damage the important relationships on which you relied upon in the first place.

The bottom line is that founders must be knowledgeable of securities laws if they want to raise money in a Friends and Family Round, or any other kind of outside fundraising effort.

 The first thing to is to understand what a “security” is.

“Security” has a very broad legal definition[1], but is effectively a catch-all term for most of the kinds of investments an entrepreneur would offer in a Friends and Family Round.

Next, understand that every issuance of a security must be registered with the Securities Exchange Commission (and likely your state’s securities regulator as well) unless a particular exemption applies.

Formally registering a securities offering with the SEC can be prohibitively expensive and a long time, so the goal of a new business is to find an appropriate exemption to use.

However, in order to qualify for an exemption, you generally must first do some due diligence on who your investors are and how you “sell” your investment offering to them. It is critical to have certain legal documents, both on behalf of your corporation (board minutes, stock plans) and that are furnished to your new investor (term sheets, subscription agreements, investor questionnaires).

You should appropriately maintain these documents and be able to quickly and easily verify the legal ownership in your venture after the Friends and Family Round is complete.  For example, you may put together a cap table showing who owns what and there are many services out there that help you maintain your cap table. However, for each investor shown on it, you should have corresponding board minutes to confirm the corporation approved the offering and a subscription agreement or other agreement signed by the investor clearly identifying the nature and risks of their investment.

To be frank, the best thing for an entrepreneur who is trying to raise outside money to be is scared.

There are a lot of technical and legal issues under securities law that are often unknown to an inexperienced entrepreneur or founder, but approaching the process with a healthy dose of fear could protect you from costly mistakes. If you are a business owner hoping to learn more about how you can properly raise money or offer securities on behalf of your business, please contact the Law Offices of Daniel T. Goodwin today!


[1] The formal definition under Federal Securities Laws is “any   note,   stock,   treasury   stock,   security   future,   bond,   debenture,   evidence   of indebtedness,  certificate  of  interest  or  participation  in  any  profit-sharing  agreement,  collateral-trust  certificate,  preorganization  certificate  or  subscription,  transferable  share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided  interest  in  oil,  gas,  or  other  mineral  rights,  any  put,  call,  straddle,  option,  or  privilege on any security (including a certificate of deposit) or on any group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle,  option,  or  privilege  entered  into  on  a  national  securities  exchange  relating  to  foreign  currency,  or,  in  general,  any  interest  or  instrument  commonly  known  as  a  ‘security,’   or   any   certificate   of   interest   or   participation   in,   temporary   or   interim   certificate  for,  receipt  for,  guarantee  of,  or  warrant  or  right  to  subscribe  to  or  purchase, any of the foregoing.”  Section 2(a)(36) of Investment Company Act of 1940, 15 U.S.C. § 80a-2(a)(36).

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