To meet their earliest financing needs, startup founders often turn to so-called “friends and family” for funding. This early-stage financing can help bridge the gap for a company that needs capital but is not yet at the point where it is attractive to angel or venture capital investors. There are, however, reasons to be cautious when considering a friends and family investment round. Handled improperly, a friends and family round could expose the company and its principals to liabilities under state and federal securities laws and otherwise make it difficult to raise capital from other sources down the road.
Securities Law Considerations
Perhaps the most important thing to keep in mind when considering a friends and family round is the need to ensure compliance with state and federal securities laws. The securities laws do not distinguish between friends and family rounds and financing provided by other types of investors. Therefore, even in the context of a friends and family round, any sale of securities must be either registered or exempt from registration. Given the prohibitively high costs associated with registration, startups will instead seek to find an exemption from registration.
On the federal side, one of the most common exemptions used in the friends and family context is that for sales not involving a public offering and the related safe harbor provided by federal Rule 506. Under that safe harbor, sales can be made to accredited investors (i.e., those that meet certain income, net worth and sophistication tests) without the need to prepare extensive disclosure documents. Sales made in a Rule 506 offering to non-accredited investors must be accompanied by disclosure documents that are generally as extensive as those used in registered offerings. If a company wishes to utilize a Rule 506 exemption, the company must file a notice on federal Form D with the Securities and Exchange Commission within fifteen (15) days following the first sale. Although federal law generally preempts state law in connection with Rule 506 offerings, certain state requirements must be satisfied as well. In New Hampshire, those requirements include the filing of a copy of the federal Form D and New Hampshire Form D-4 (the Issuer-Dealer Notice Filing Application) and paying the applicable filing fees.
Outside of the Rule 506 context, a New Hampshire state law exemption that can be applicable to a friends and family round is one that allows for the issuance of securities to no more than ten (10) purchasers in any twelve-month period, assuming all of the other requirements of the exemption are met. While the company may issue securities to more than ten (10) if the period exceeds twelve months, there is a lifetime cap of issuances under this exemption of not more than twenty-five (25). This particular exemption is deemed to be a so-called self-executing exemption, meaning that there is no filing required when securities are issued. A company relying on this exemption should be careful to verify that each purchaser is a New Hampshire resident; otherwise, the securities laws of other states will apply.
Selecting the Investment Type
Another important issue to consider is what type of investment to offer in a friends and family round. One popular alternative is the issuance of debt that is convertible into equity. Typically, the events that trigger the conversion are either the closing of an equity financing by the company or the sale of the company prior the maturity date of the debt. Convertible debt most commonly converts into the type of securities being sold in the equity financing, upon the terms of the equity financing (perhaps at a discounted price or subject to a valuation cap). If the debt converts upon the sale of the company, the debt usually converts into a class of equity that existed at the time the debt was originally issued. Primary rationales for issuing convertible debt (instead of straight equity) are:
- to raise capital for the company in a relatively cost-effective way,
- to bridge the company’s financial needs between the issuance of the convertible debt and the equity financing that triggers a conversion of the convertible debt, and
- to postpone establishing a value of the company.
The maturity feature of convertible debt distinguishes it from some other forms of financing that are increasingly of interest to startups, namely the SAFE (i.e., Simple Agreement for Future Equity) and other convertible equity structures that otherwise share many features with convertible debt. As is the case with convertible debt, these structures can be tailored to suit a company’s needs.
Another alternative is the sale and issuance of common stock (rather than preferred stock that is generally required by venture capital and other professional investors). In many cases, a primary motivation of the friends and family investors is to support the entrepreneur, and not necessarily to maximize the opportunity for a significant investment return. Thus, friends and family may be willing to purchase common stock, which is a relatively cost-effective and straight-forward way for an early stage company to raise capital.
Managing Investor Expectations
Finally, a founder handling a friends and family round needs to be an expert in expectation management. The fact is, most startups do not become the wild successes entrepreneurs expect. Those investing in the round need to be comfortable with the possibility that they may lose their entire investment, and that the investment may not provide them with a retirement nest egg. The founder should be sure that the friends and family are aware of exactly what their investment is – an early investment in a very high risk endeavor.
Because of the nature of the risk in a startup venture, setting appropriate expectations is important to mitigate the chance of misunderstandings and to preserve family and friend relationships.
