Friends & Family: The Good, the Bad, and the Ugly
In general, owners of start-ups and early-stage companies wait too long to begin their capital raising efforts and in doing so, put their operations in jeopardy. As with any round of funding, entrepreneurs should be concerned with attracting the proper amount of money, and do so with the least amount of dilution and hassle.
The Friends & Family round is the most frequently employed source of funding for start-ups and early stage companies. And while there are many advantages to this form of capital raising, entrepreneurs should be wary of some of the direct and indirect consequences that frequently surround the journey.
For those business owners choosing to employ the Friends & Family approach, there can be many benefits. Often overlooked in the grand scheme is the comfort factor. No formal introductions are necessary as the investors are familiar and comfortable with the business owner. For those entrepreneurs that are nervous or intimidated about meeting with institutional investors, this can be a major advantage.
Coinciding directly with the first observation, Friends & Family are usually not as sophisticated as investors at other funding stages. As such, business valuations, financial projections, and underlying assumptions may not be scrutinized as intently as other rounds.
Finally, Friends & Family capital formation normally affords the quickest access to funding with assets being made available in a matter of weeks and months rather than months and years with other rounds. This can be a significant advantage to those business concepts that require a sense of urgency or immediacy.
While the Friends & Family funding round may offer important advantages over the other funding methods which can be arduous at times, it can be catastrophic if business owners do not identify and cover all the proper angles beforehand.
As noted in our narrative, Proper Funding: One Size Does Not Fit All, gathering funds from Friends & Family can be fraught with considerable regulatory issues. A common misconception among entrepreneurs is that a Friends & Family round is somehow exempt from U.S. securities registration.
We can state emphatically that there is no Friends & Family exemption from U.S. securities registration requirements. Both federal and state law requires that any entity selling securities (whether it be debt or equity) must have them registered with the Securities and Exchange Commission (SEC), as well as the state securities commissioner of each state where potential investors reside. The consequences of not adhering strictly to these regulations can be severe. Violation of securities laws can result in criminal prosecution of the company’s owners and principals, as well as severe monetary penalties.
Many business owners do, however, make an effort to comply with securities laws. Most often they seek exemptions from the registration requirements under the Securities Act of 1933. Start-ups and early-stage companies frequently utilize Regulation D and Rule 506 as the exemption to some of the registration guidelines.
Under Rule 506 of Regulation D, there are two distinct routes from which an issuer can claim exemption. To avoid any confusion, the following text is from the SEC website.
“Under Rule 506(b), a company can be assured it is within the Section 4(a)(2) exemption by satisfying the following standards:
- the company cannot use general solicitation or advertising to market the securities;
- the company may sell its securities to an unlimited number of “accredited investors” and up to 35 other purchases;
- Companies must decide what information to give to accredited investors, so long as it does not violate the antifraud prohibitions of the federal securities laws. But companies must give non-accredited investors disclosure documents that are generally the same as those used in registered offerings. If a company provides information to accredited investors, it must make this information available to non-accredited investors as well;
- the company must be available to answer questions by prospective purchasers; and
- financial statement requirements are the same as for Rule 505.
Under Rule 506(c), a company can broadly solicit and generally advertise the offering, but still be deemed to be undertaking a private offering within Section 4(a)(2) if:
- The investors in the offering are all accredited investors; and
- The company has taken reasonable steps to verify that its investors are accredited investors, which could include reviewing documentation, such as W-2s, tax returns, bank and brokerage statements, credit reports and the like.
Purchasers of securities offered pursuant to Rule 506 receive restricted securities, meaning that the securities cannot be sold for at least a year without registering them.”
By definition, an accredited investor is someone who satisfies either of the following:
- an individual net worth (excluding value of the primary residence) exceeding $1,000,000, or
- individual income in excess of $200,000 ($300,000 married) in each of the two most recent years and has a reasonable expectation of reaching the same income level in the current year.
If that is not enough, non-exempt, non-registered offerings can disrupt future transactions, bring about government investigations, and lead to an expensive rescission offering. Moreover, we can assure you that additional funding rounds will take on a different complexion once any prior non-registered offerings are discovered.
“and The Ugly”
Beyond the legal ramifications, which extend well beyond this narrative, investing in a Friends & Family round is not like depositing funds into a bank where the assets can be removed at a moment’s notice via an ATM. Investors need to understand that putting money into a project carries with it a certain degree of liquidity risk. Invested funds may be locked up and unavailable for several years.
Entrepreneurs should also realize that when they opt to pursue Friends & Family capital, they are effectively aligning their business interests alongside retail (individual) investors who possess certain unpredictable qualities. To this end, numerous textbooks have emerged in recent years regarding a relatively new sphere of investment analysis called behavioral finance. This field of study investigates some of the behavioral biases that lead certain factions to make irrational decisions.
A common misconception of Friends & Family funding is the belief that being an equity shareholder automatically provides the investor with a degree of authoritative influence or control over decision making and day-to-day operations. Nervous investors can disrupt ventures with frequent requests regarding product or service performance and the need for regular business updates.
Beyond these rather benign distractions is the real risk of future legal actions if business progress or performance is less than what a friend or family member believed when making the original investment. Not fully grasping the concept of liquidity, its associated risks, and the investment horizon stipulated at the outset can also lead to costly lawsuits that can drain valuable resources.
Investing in business ventures alongside relatives can have tragic consequences for family relations. A failed business concept can create considerable stress during holidays and family gatherings and, even worse, form permanent splits.
Our advice is simple and direct with respect to any form of funding, but particularly with the Friends & Family round:
- do your homework,
- hire a securities lawyer,
- get proper federal and state registration, and
- consider the social and psychological ramifications that a failed or troubled business venture may bring.