131. Friends & Family Round: How to Protect Your Relationships AND Raise Money
Full Episode on YouTube
TL;DR: The friends and family round is most founders' first fundraise, and the easiest one to screw up. Your investors probably don't understand what they're getting into, the power dynamic is reversed (you know more than they do), and sloppy documentation can torpedo your next round. Use a SAFE, give generous terms, be honest about the risks, keep investors updated, and never let anyone invest more than they can afford to lose. This guide walks through exactly how to do it right.
The friends and family round is the first time most founders have tried to raise money from investors. And if you make a mistake, it can screw over the people who are trying to help you, torpedo your next investment round, and ruin Thanksgiving forever.
So let's talk about how to do it right.
Your friends and family really want to help you and your business succeed, but they probably don't understand what it is you're asking of them. There's a very unequal distribution of knowledge and power here, and unlike every other fundraising round you'll ever do, the knowledge and power is in your hands, not the investor's.
That flipped dynamic means you have an ethical obligation to get this right. Here's how.
Make Sure They Know What They're Getting Into
What Friends and Family Investors Need to Understand
The first and most important thing you need to do is educate your investors. There are several things it's critical that you make clear to them.
This is an investment, not a loan. This is not something that's going to get paid back. It has a very high degree of risk. The odds are that they're going to lose their entire investment. There's a very small chance of very high returns, but until you go through an exit, they will be totally illiquid. There's no way for them to easily get their money back out, and that's probably not the way they're thinking about this at first.
They're shareholders, not partners. This is not some limited liability corporation where they're joining you on this journey. They're investing cash into the business and getting a piece of the ownership, but not operational involvement.
Their ownership percentage will shrink over time. As you give out stock options and bring in additional investors, they'll get a smaller and smaller piece of what is hopefully a bigger and bigger pie. This may surprise them, but you need to help them understand that dilution is actually a good thing. When you're bringing in more investors, it means the business is being successful and growing, and that's how success is going to come at the end of the day.
Explain your use of funds. Make sure they know what you're going to do with the money. How are you going to spend this? How does taking this money in help the business hit the next milestones that will allow you to grow the company and potentially raise rounds from outside investors, like angels and VCs? It's important for them to know that this is not just going straight into your pocket. It's not going to pay your rent. It's not going to help you buy that next car. This is an investment to grow the business, and it is vital to the functioning and success of the company.
That's a lot to explain, and it can be awkward coming from the person asking for the money. So I created a video you can send directly to your friends and family investors that walks through all of this from a disinterested third party. I've done this hundreds of times with other founders and worked with hundreds of different investors, so I can explain why what you're asking is very reasonable and exactly how it works. Just send them this link:
https://ftb.bz/friends-and-family-explainer
Document Everything. No Exceptions.
How to Structure a Friends and Family Investment
It is critically important to document this investment completely and carefully. Nothing can be casual about this. It should not be a handshake deal or a verbal agreement. You want to make sure that they're on your cap table, and you have all of the contracts signed supporting the investment and their ownership.
This is both to protect them, but even more to ensure that you are able to do your next funding rounds. If an investor comes in and sees that there's any ownership on your cap table that's not fully documented and supported by agreements and contracts, they will run for the hills, because that's just asking for lawsuits down the road.
Why You Should Use a SAFE for Friends and Family
When you document it, I recommend you keep it simple and use a SAFE, a Simple Agreement for Future Equity. That's a tool that was created by Y Combinator, and you can find the standard SAFE templates here. All you really need to fill out is the cap on the valuation, any discount, and that's basically it.
The SAFE guarantees that your friends and family investors will get whatever deal your next large investor negotiates. They'll be the ones doing all the negotiating, and you're not asking your friends and family to understand all of the terms and conditions that go into a priced equity round.
Now, the downside of SAFEs is they can look a little weird. If your family is reading through the document, they're going to realize that they're not actually getting anything when they sign the SAFE and pay you the money. It's a promise to give them something later at an undetermined price when there's a conversion event. So it may take a little time to talk them through it, and that investor explainer video I linked above can help. The SAFE is the most common instrument used for investors in early-stage companies throughout the world, and once they understand that, they'll be much more comfortable.
Give Them a Good Deal — They've Earned It
Setting Terms for Early-Stage Startup Investors
Because you're probably going to dictate the terms, your friends and family are not sophisticated investors who will negotiate hard, give them a good deal. These are your friends and family. They're coming in incredibly early, usually earlier than any rational investor would. This round is often called the friends, family, and fools round for a good reason.
So give them a generous discount because they're coming in so early. Maybe even a 50% discount to the next round, where 20% is more standard for later investors. Reward the risk they're taking on you.
What Is MFN (Most Favored Nation) Status?
One of the covenants you can put into a SAFE is called MFN, Most Favored Nation status. It means that if you bring in an investor later and give them a better deal for whatever reason, your friends and family have the ability to convert to take that deal instead.
It protects them. It makes sure that these people who are supporting you in these very early days are getting the best deal possible. And that really is the key to managing this round: the ethical and necessary thing to do is to make sure that you're doing the right thing by them.
Protect the Relationship
Don't Let Investors Overcommit
When I was raising money from my family early on, I was a penniless grad student when I started my company, my folks helped me out. They were not rich. They were college professors, and in fact, their financial advisor basically bullied them into putting most of their assets into a structure that they couldn't access to invest in me because he'd seen too many startups.
Founders drain their parents dry and wipe out all of their retirement savings on the company because the parents always think, "Ah, this next check might get them out of there."
I could never disagree with what that guy gave them as advice. Make sure that you're not putting your parents and friends into that kind of situation.
If someone doesn't have deep pockets, this could be a substantial chunk of their assets. You should never be asking anyone to make an investment that they can't reasonably afford to lose and have locked up for a decade or more. If someone's got limited means, even though you might like to be taking a bigger investment, make sure you don't. Take what they can afford to lose so that you're not putting them in a really difficult position.
Be Honest About Your Startup's Prospects
Be honest with your investors about where you are in your journey and your realistic prospects. Don't paint an overly rosy picture that they're then going to be wondering why things aren't going as well as you projected.
Try to be realistic about this, and keep them in the loop. Nothing's worse than an unhappy surprise two years in. If you're giving them updates once a month or once a quarter, they'll know what's going on, they'll see how hard you're working, they'll see the progress that you're making, and it will make them much more comfortable with the outcome, even if that outcome isn't everything you'd hoped for.
Once you get your Friends and Family funding, you need to make sure you survive to give them good returns on their investment. That starts by avoiding the top ten startup killers. You can read more about them here.
