How To Structure Friends And Family Investment

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Hone In On The Right People

Friends & Family | Equity Funding Fund Your Business | Dun & Bradstreet

Receiving a gift or a loan is pretty straight forward, and you can ask practically anyone you trust and who has the available funds. When it comes to equity or convertible notes however, you need to put some more thought into it. Like finding the right investors who will add value in larger rounds, you should determine if these friends and family investors have a professional background, and who really understands the risks and benefits associated with financing your idea.

What Is A Private Investor

The short answer: A private investor is a person or company that invests their own money into a company, with the goal of helping that company succeed and getting a return on their investment.

The long answer: The field of private investment is more varied than the short answer might make it seem at first. Itâs important to note that while private investors may be from firms that focus solely on investments â like venture capital firms and angel investors â they are never from banks .

Rule #: Be Very Specific About What Outcomes You Plan To Achieve With The Money

While at this stage it isnt absolutely needed to have a robust pitch deck, executive summary, and financial model to share with your friends and family, the more you have in place, the better. If you think about it from an investors perspective, they should know exactly what they are getting themselves into and the asset they are betting on having market value down the road to earn a return.

Youll need to get in the practice of having updated documentation for your investors as you raise later rounds, but for now – focus on a specific plan for what you aim to achieve in terms of your product, marketing, sales, and team growth.

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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.

Similarities Between Family And Friends Funding And Other Forms Of Financing:

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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.

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.

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Benefits Of Friends And Family Financing

Generally, friends and family financing does not involve the formal review process or due diligence involved in commercial loan or angel investment situations. That is, friend and family are not going to conduct a thorough review of your credit history or require extensive collateral to secure the loan. The friends and family relationship is also generally flexible with regard to repayment options and applicable interest rates.

Back to: Entrepreneurship

Friends And Family Round Vs Angel Round

Many entrepreneurs setting out to found a business believe they should begin by focusing on venture capital. That, however, is a misconception: in reality, venture capital comprises only a small percentage of startup financing. For startups, there are two common sources of early-stage financing.

This article briefly describes the differences between two common sources of early-stage financing for startups.

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Advantages Of Friends And Family Funding

There are many clear advantages of getting your funding from people who know. They know your potential and understand the probability of your business succeeding.

Friends and family lending can take place on a much larger scale and on a formal basis. Peer-to-peer websites, angel investments, venture capitalists, and bank loans often have stricter legal requirements. They have criteria that have to be met before the investments can be secured.

Friends and family investments are a much more flexible solution for your startup. Friends and family investments are easier to raise compared to all other investments.

It is possible to gain investment from friends and family even before the completion of the business plan. Youâll secure the investments from mutual trust rather than the validity of the idea on paper.

Conventional sources often require proof of the profitability of the business, sales, and other more technical factors. Those requirements make it hard for a business that requires funds to set up. Thatâs because it is hard to prove that a business concept would earn money without any real trial.

Family and friends already know the character and circumstances that you are bringing to the table. And may not require an extensively detailed business plan.

They offer investment on their knowledge of abilities. Hence one does not have to prove to the family member or friends what they are really capable of doing.

Understanding Friends And Family Shares

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Friends and family shares are offered to people close to the heads of a startup. When it comes time to issue friends and family shares, which are also called directed shares, the lead underwriter for an IPO typically agrees to administer friends and family shares as a service to the issuer.

These shares are normally sold to friends and family at a discount from the price set for the IPO. By buying shares, these associates get a stake in the company’s success, just like any other .

The number of shares offered by a company typically represents a small percentage of the company’s offering. This is normally less than 5%. But while the number of shares one person holds may be small, they may create significant gains for the holder, especially if the company is successful.

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Convertible Notes And Convertible Equity

Convertible notes and convertible equity allow a company to receive cash from an early investor without the premature valuation issue discussed above. This is because the convertible security holder does not receive company stock at the time she invests, but only the right to receive stock at the time of a future financing .

This approach has significant benefits for your friend or family member for two reasons. First, the stock she receives will be on the same terms as later investors, which typically include a number of preferences over common stock holders. Second, she will likely receive a discount and other perks compared to the later investors to compensate her for taking a risk on the business at an early stage.

But there is a significant risk for the company with using convertible securities for friends and family if he or she does not meet the securities laws definition of accredited investor. This is because the future financing will almost always take advantage of a federal securities exemption that relies on all the investors in the round being accredited investors. Even one investor who does not meet the definition of accredited investor can destroy the exemption, causing significant securities compliance issues.

Thus, convertibles are a great tool if your friend or family member qualifies as an accredited investor, but it is not advisable to use convertibles for other friends and family transactions. For questions contact a business attorney at SPZ Legal.

How Deloitte Can Help

Deloitte can field a world-class team to guide family offices through these critical conversations and clear a path forward. We have a global team of 1,800 professionals across the Deloitte Touche Tohmatsu Limited network of member firms who focus solely on the specialized needs of the ultra-affluent, including families with multigenerational wealth, entrepreneurs, family offices, and fiduciaries. Our professionals provide advice and deep experience in a wide range of specialized areasfrom tax technical to cyber risk managementand have access to a global network and emerging markets.

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Raising The Funds Needed

Before opening the fund, you will need to contact your friends, family members, and close acquaintances for fundraising. Part of raising capital is having a business plan that investors are able to understand so that all of the individuals are on the same page.

After you have raised the startup funds, you will be ready to start your own investment club with the money that was raised. The first step would be to have a meeting with an experienced lawyer who specializes in investments to form the partnership agreement and structure the fund in a way that will allow the fund to meet business goals and have the best tax implications for the fund.

Dedicated Team Or A Family Team

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When managing money for friends and family, it is important to have experience in managing others money. This may include education, certificates, knowledge, and experience. This is to ensure that the fund is able to generate returns from the family investments and other investor money if the fund chose to include them.

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Determine How Much You Need

Its easy to shoot for the moon when youre riding high and just getting started on building your new dream companybut one of the purposes behind a Friends and Family round is that its really meant to be just a kick-start. Rather than estimating the maximum amount of funding you can pull in, think strategically and logically instead. Build a four or six-month plan, and determine how much cash it will cost to buy all the needed inventory and assets, plus any financing you need for early-stage employees. By being very logical with your initial ask, you are in a better position to request additional dollars if the business is still going according to the plan in a few months.

Where To Find Private Investors

Finding private investors depends on the type of investor a startup is looking for.

Weâre not going to go over family and friends, because thatâs obvious, and weâre also not going to go over private equity, for all of the reasons outlines above.

But letâs take a look at the other two main types of private investors.

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How Much Capital Should You Ask For

There is no right or standard number to go off of here as this completely depends on how much you need to get you through the first few months of your business until you either are making a profit or are ready to raise another round. Ranges are usually anywhere from $10,000 to $150,000 but can also go up to 2 million. Use modeling and advice from the market to get a ballpark idea. You can check out a template for modeling your early financials here.

Getting An Investment Strategy Purpose And Goals

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Before starting the investment club, investing in businesses and talking to friends about the fund, you will need to take a step back and see what the goals of the family and friends are.

If the main purpose of the fund is to simply preserve the wealth the family currently has while also growing for future generations. Some family members and friends might not understand that the higher the returns, the higher the risks.

An individual will need to take the familys background into consideration in regards to long-term growth, generational wealth and collaboration, and community outreach for example. Once these have been established, the organizer is able to go on to the next step.

Some families and friends like to include their shared values and social responsibility into the fund. For example, some families will have social and environmental benchmarks they would like to meet. This may include not investing in companies that engage in deforestation or not doing business with companies that are engaged in unethical behavior.

Having a vision for the fund is an important part of having a family and friends fund because after all, its purpose is to grow wealth. By having a vision set in place, you are able to include the vision into their wealth growth and preservation.

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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.

What Is A Friends And Family Investment Fund

A friends and family investment club can take many forms. The first relevant factor is what you are all going to be investing in. It might be a startup or business/es, or it might be in stocks, shares, or other financial assets.

Beyond that, the principles are fairly similar. The basic principle is that you all pool your investments so that you can have a collective interest in an asset that you all agree is likely to increase in value over the coming years.

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Business Loans From Family And Friends

Small business loans from family and friends are a common way for them to give you the money you need to get your venture started.

Friends and family loans are often early in the history of your business, around the pre-seed or seed funding stages. In some cases, entrepreneurs also use startup funding from family and friends as a bailout option when things are not going well over the short term.

Like any loan, a friends and family business loan can include an interest rate that determines how much you pay back overall.

However, it’s also quite common for friends and family investors to accept an interest-free arrangement just because they want to see you succeed.

Either way, make sure all parties are very clear about what you have agreed and put the repayment terms in writing so there can be no disputes later.

Common Stock With Promissory Note

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Another option for your friend or family investment is a combination of equity and debt. To do this, you would issue your friend or family member common stock at par value as well as a promissory note for the remainder of the funds .

This approach is beneficial to the friend or family member for two reasons. First, receiving an ownership share of the company means that she will share in the upside of the company. Second, because the promissory note is a debt instrument, she has a right to have her investment paid back with interest.

This approach is also beneficial for the company. Because the common stock is purchased on the same terms as the companys founders , this avoids the valuation issue with the common-stock-only approach above.

From the companys standpoint, the issue with this approach is that the company is taking on debt, which is not necessarily the best way to get started with a new business if it can be avoided.

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Rule #: If You Must Take Money From Friends & Family Clearly Warn Them Of The Extreme Risks

At this point its important to be extremely honest with yourself and with your family/friends: the most likely outcome here – statistically speaking – is that your startup will not earn a return for investors. In fact, the highest probably is that the return will be zero.

Experienced startup investors understand these odds, which is why they build out a diverse portfolio, expecting most of their bets in startups to fall flat. However, your friends/family might not have this strategy in mind when investing in your startup, so youll want to think of the relational dynamics at the next Thanksgiving dinner. Ideally you should have a direct conversation with them in advance where you hear them say something to the effect of: Yes, I understand that I will most likely be losing all of this money, but Im willing to take that bet on you and your startup.

Furthermore, another important issue to address with inexperienced startup investors is the illiquid nature of the investment. Even if there is a return, it may not happen for 7-15+ years . In the mean time, selling off the stock isn’t nearly as easy as it is when dealing with public stocks, so be sure that people who give you money understand this.

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