Nutshell: A friends and family round should look, contractually, much like your first angel round, and it will be subject to all the same rules/laws. However, there are a few crucial differences that will ensure (i) a smooth transition from F&F to angel money, and (ii) that your friends and family were given fair economics for all the risk they took on.
Before anything else, let’s get the definition of “friends and family round” out of the way: a financing round… involving only friends and family.
Notice how that definition doesn’t sound very “legal” or “official?” That’s because it isn’t. There is no legal definition of “friends and family round” because the term is meaningless with respect to all the regulatory restrictions/requirements that go into raising money as a startup. Everything still applies. Most importantly, if you want to eventually raise VC money and aren’t totally desperate, those friends and family still need to be accredited investors, just like angels and VCs do.
Good Background Reading:
- Founder Convertible Notes: Put Your Money on the Cap Table
- Founder SAFEs: Alternative to Founder Notes
- Taking Non-Accredited Money: Survival
It’s well known and documented that the average cost of “starting” a startup and getting to a professional funding round is, today, a fraction of what it was 10 years ago. And while that’s very true, a lot of founders have taken this fact to a conclusion that doesn’t quite fit with reality: that you can start a tech company with very little money, and bootstrap your product until angel investors find it attractive enough to close a seed round. This works for a limited number of businesses and groups of founders (with strong technical skills), but the truth is that for a whole lot (most) of tech companies it still takes at least $75-$200K of capital to get to a point where even angels will find it attractive.
Reality Check: Before Angels, You Still Need Money
Angel investors, especially angel investors in Texas, very very rarely fund ideas or even MVPs. They fund companies who can show credible traction with paying, or at least strongly interested, customers. All the cloud products and X-as-a-Service economics don’t change the fact that getting there usually takes some real money. The result is that, in the vast majority of instances I’ve observed, founders who close on seed money were supported first either by a decent amount of their own funds, or by affluent (accredited) friends and family.
Truth: many, if not most, founders who start successful startups are not coming from working class, or even middle class backgrounds. They’re able and willing to take risks many others won’t because they have a personal support network to (i) fund them before professional angels are interested, and (ii) keep them from hitting rock bottom if everything blows up. That or they’ve already earned some money and have built their own bootstrap fund. They’re still ballsy risk-takers, no doubt, but they usually have parachutes unavailable to a good portion of the population. In any event, they are not attending pitch competitions or angel meet-ups before they even have a functional product, credible traction, and a rational business model. They use F&F money first to get there, and then go after angels.
As a side note: I’m not writing the above to discourage anyone without affluent friends and family or a decent savings account from pursuing their dreams. I’ve of course also seen successful founders who risked actual homelessness to build their companies, but those are few and far between. If you’re going to do it, at least know what you’re getting into, and what resources others had available to them before they themselves took the plunge.
The Structure of a Friends and Family Round
So friends and family rounds are important. Very important. A few key principles for structuring one:
- Everyone should still be an accredited investor.
- To keep legal costs down, it should look (on paper) exactly like a small seed round with angels (convertible note or SAFE with discount to future Series A price), save for a few crucial differences (described below).
- Unless someone in your F&F group is a professional angel investor who is comfortable setting a valuation on your company, it should under no circumstances have a valuation cap.
- It should contain what’s often referred to as an “MFN” (most favored nation) provision allowing the terms to be amended and restated to be on par with the next financing round (when angels get involved). This ensures that the lack of a valuation cap does not result in your later investors (who usually insist on a cap) getting a better deal than your biggest risk-takers (your friends and family).
The reason for not having a valuation cap is simple: if you don’t know what you’re doing, you’ll either (i) make it too high and signal to future investors that you’re a bit clueless, and it will look bad if your next money gets a lower cap than your earlier (highest risk) money, or (ii) you’ll set it too low, and future investors will use it as a starting point for arguing why their valuation cap should be low as well.
A convertible note with a discount on the Series A/AA price, no valuation cap, and an MFN provision is the most common structure for a F&F round. However, it often makes sense to provide one extra provision that, while totally logical, isn’t quite convention: the MFN should ensure that your F&F get a discount on the valuation cap that angel investors get.
The classic MFN in a F&F note ensures that, at best, your F&F will get the same terms as your first angel investors. But obviously your friends and family took on way more risk than even your earliest angels will. Though it means a bit more dilution, if you want to be as fair as possible you’ll ensure your F&F MFN includes language amending the F&F notes to include a valuation cap that’s, say, 20% lower than your first angel notes. Most friends and family won’t ask for something like this, because maximum return is not their primary motivation in writing you a check: but many founders would agree it’s the right thing to do for the people without whom you could never have built the company.
Finally, the above principle can logically be applied to Founder Convertible Notes as well. If you’re papering investment in your own startup well before angels will even talk to you, you shouldn’t be setting a valuation, but there’s a good argument for why it should still receive terms that are at least slightly better than what your first angels receive.