Turning to friends and family for financial support for a high impact startup is a popular move for many entrepreneurs, particularly in places where seed stage professional risk capital sources are few and far between. A common and justified worry about these transactions is that theretofore close relationships between investors and investees can come under serious strain if the new business struggles or even fails (hey, it happens). And this is, indeed, something the people on both sides of these transactions should think hard about before entering into a deal.
But there are other, more often overlooked, problems with friends and family investment transactions; problems that can seriously undermine a start-up’s longer term prospects even when the business hits its early stage milestones and appears well positioned to attract institutional capital and take the next steps. Fortunately, these problems can usually be avoided if the parties are smart about the way they structure friends and family investments.
The first of these problems, and the subject of this post, involves the laws relating to issuing ownership interests in businesses. State and federal securities laws regulate all sales of equity interests (lets call them “securities”) in a business – including debt that can be converted into equity at some future date. Unless and to the extent a particular sale of securities is “exempt” from the default rules, the regulations are extensive. In the context of sales of securities by startup businesses to individuals – family, friend or otherwise – unless the individual in question is an “accredited” investor (basically, very wealthy) the rules governing how, what, and when prospective investors are offered an opportunity to invest in a business are specific and extensive. Simply telling your friends and family that the business is risky and they might lose all their money if they invest is a good start, but by itself not nearly enough to comply with the applicable regulations.
Many entrepreneurs (myself among them, back in the days) occasionally go down the “better to beg for forgiveness than ask for permission” path as they build their businesses. Alas, when it comes to state and federal securities laws, that is seldom the right path. If, after the deal, things go south, the friends and family that invested can, among other things, seek their money back from the company and, ultimately, the entrepreneur who sold them on the investment. Worse than that, if things go well, the existence of the investors who acquired their interests in the company in contravention of the applicable securities regulations can – and I’ve seen this happen on multiple occasions – make raising downstream capital from venture capitalists or other sophisticated investors more difficult and expensive than without the friends and family complications, and even in some cases impossible.
The issue, for the potential downstream investors, is three-fold. First, depending on the timing and other circumstances, the improper friends and family offering can legally taint the subsequent offering, regardless of how that subsequent offering is conducted. In this case, time – something entrepreneurs generally don’t have a surplus of – is usually the only cure. Second, if subsequent to the friends and family investment the deal goes south, downstream professional investors might find themselves with the proverbially deep pocket when the earlier investors find that neither the company nor the entrepreneur have the money to pay them back. Third, even if the deal is a hit, the earlier investors might (particularly if they paid a higher price than the later investors) still argue that they were gouged on price in a transaction that violated applicable securities laws and should be compensated for that – by the company; which, ultimately, means the other shareholders of the company including the downstream investors.
Now, given all of the risks venture capital and other sophisticated risk capital investors take, it might seem like the above risks are not all that significant, and should not deter an otherwise interested investor from doing a deal. A couple of thoughts. First, don’t confuse venture capitalists’ willingness to take risks with a willingness to take unnecessary risks. A deal has to be unusually compelling (and/or the price unusually attractive) to make investing in a company known to have materially violated the securities laws worth doing. Second, even if the ultimate cost to the company of “fixing” a securities law problem, in terms of paying off the aggrieved investors, turns out to be modest, the costs in terms of management time and distraction (the company’s and the investor’s) and other litigation-related expenses can be significant as well. The bottom line is that in the large majority of cases there are enough deals out there without these kinds of problems to make doing a deal with this kind of problem baked in look like a bad idea.
The cleanest way to avoid a friends and family securities law trap (other than limiting the transaction to friends and family who are accredited investors, where applicable state and federal regulations are generally easier and cheaper to comply with) is for friends and family to lend money directly to the entrepreneur for subsequent use by the entrepreneur in his discretion in the business. The friends and family investors in that case become creditors of the entrepreneur, not the company, and in any event no equity interest is transferred. (Perhaps, independent of the loan (there can be no quid pro quo involved), the entrepreneur might gift a friends and family creditor with some small piece of the entrepreneur’s own equity in the business.
A good question here is “well, why should my family and friends lend me money for my risky new business if they don’t get any upside beyond getting their money back with interest?” Well, presumably they are investing because they are friends and family, right? That has two implications. First that they are motivated mainly by wanting to help you out, and not to make a killing (at least that’s been the situation for me on occasion). Second, they presumably trust you, and you presumably trust them. While there can be no agreement or understanding, at the time the friend or family member lends you money for the new business that they will ever get an interest in the new business (and your written agreement should make that clear), well, if they trust and respect you, and you trust and respect them….
Friends and family can be and often are a great way to get some early capital to build a new business.. But as with many generally good ideas, it’s the details that make or break the deal. And one other thing: do it in writing. It never ceases to amaze me how even the closest friends and family members develop differing recollections about the terms of a deal after the fact, when the business has either taken off or cratered.