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Starting a business is a huge financial responsibility. When you’re just starting up, you’ll need some cash in your pocket to get the ball rolling. And the first people you might turn to for support are your friends and family. You might have heard of this as the “friends and family round”.
Raising capital means getting funding from others that would help your business grow. You can raise capital from friends and family through two main ways – debt or equity. Though it might seem simple, there is a right way to raise capital from friends and family.
Too often many startups get this wrong, as they think friends and family are an easy first opportunity for some extra $$. But even when you are doing business with friends and family, you need to treat them with the same level of professionalism as you would with any other investor.
In this article, we’ll walk you through how to raise capital from friends and family the right way.
Debt Or Equity – Which One Is Right For Me?
Your first step is deciding how you want to raise that capital.
There are many different ways you can get some early cash to get your business running (for a broader understanding on financing your business, head over to our Finance Guide here). But when you reach out to friends or family, generally your options are debt capital or equity capital.
Debt
When you turn to friends and family for debt capital, this usually means you’re getting a private loan.
There are two types of private loans – secured and unsecured. Put simply, a secured loan is when you have personal or valuable assets (such as your house) that the lender takes as “security”. An unsecured loan does not have this.
And while it might seem like your friend or relative is lending you money in good faith, they might still have lingering questions. How much is the loan exactly? What’s the interest rate? When will it be repaid? What happens if the loan isn’t repaid?
To make sure you’re doing it right, and to avoid any awkward situations or relationships later, it’s better to set the ground rules and make sure your legals are straight.
The type of contract you will need is called a Loan Agreement.
If it is a secured loan, you might need to register the ‘security’ on the Personal Property Securities Register (PPSR). You might also need a separate Security Agreement.
You can find out more about loans here.
A loan is a great option if you can afford making repayments and have friends and family who’d be happy to lend you money. It’s especially good if you want don’t want to give away too much equity too soon.
But, for most startups and small businesses, this isn’t the case. Many founders cannot afford making repayments, and many aren’t willing to expose their personal assets as security.
This is when equity might be a more attractive option
Equity
Equity raising is when someone invests in your company in return for part ownership or “shares” (even if you aren’t actually making any money yet!). There are also variations of equity, such as the “SAFE Note” introduced by Y Combinator in 2013, or the more traditional “convertible notes” which we wrote about here.
Equity might sound like a win for startup founders: getting cash in their pockets now without having to pay it back. But, it has its own risks. It means you are giving away part ownership of your business. While giving away 10% of your business might seem like nothing now, this 10% could be worth $1 million in a few years. And that’s $1 million you could have kept.
This is why equity raising is an attractive opportunity to investors: it might be high risk, but a potentially big win for them in the long run.
As you can see, equity raising comes with its own risks and benefits for both startup founders and investors. So if you’ve decided to go ahead with raising equity capital from friends and family, it’s important to do it right.
So what’s involved in raising equity?
Step One: The Pitch
When you first approach friends and family for equity capital, you will need to start as you would with any other investor: with a “pitch”.
In startup lingo, a “pitch” is when you lay out your business idea, what problem it’s solving and where you see it going in the future. This is how you convince them to put their money in the growth of your startup.
So, before you do your big pitch in front of friends and family, you’ll need three things.
First, you’ll need a “pitch deck” – a presentation of simple, captivating slides that would sum up your pitch and appeal to your friends and family.
Second, it’s always a good idea to prepare a pack of documents, which includes any financial or industry evidence that would support the viability of your business idea. These documents give your pitch credibility and reassure your potential investors that you aren’t over-valuing your startup.
Lastly, you’ll need a Term Sheet. The Term Sheet essentially sets out the key terms of the investment. When requesting investment from friends and family, they might be asking questions like: how much ownership do I get in return? What relationship will this mean in the long run? How do I know my money is being well spent? A Term Sheet is your opportunity to answer these questions for them.
Having these three documents prepared for helps investors see that you’ve really thought about this and how it would work going forward, making them confident that they’re putting their money into a real business relationship.
And, if you want to be extra cautious, it might be a good idea to think about having a Non-Disclosure Agreement (NDA) in place before you start discussions with investors. This helps protect any confidential information that you disclose during your meetings (but be careful to only use an NDA in the right situations!).
Step Two: Getting It Down In Writing
So you’ve pitched your business to your friends and family and they’re keen to get on board as investors – great!
What’s next?
Now, you’ll need to think about your legals.
To make sure you’re fulfilling all your legal obligations to your investors, you need three types of legal documents:
- A Shareholders Agreement
- A Share Subscription Agreement
- IP Assignment Deed
Sounds like a mouthful, but don’t stress! We’re here to unpack it for you.
Once your friend or relative has come on board with part ownership of your company, they are officially a “shareholder”.
This is always an exciting opportunity, but you want to make sure you’re both on the same page with how this new relationship will work:
- How are decisions made?
- What happens when a shareholder wants to leave the company?
- What happens if there is a dispute?
Even if you’re in business with friends and family, having ground rules is always healthy for the relationship and business, especially as your business grows and the stakes become higher.
Which is why you need a Shareholders Agreement.
A Shareholders Agreement is an important contract between business owners that covers matters from share ownership to the process for issuing new shares, the payment of dividends, and how to resolve disputes.
If there is already an existing Shareholders Agreement, it’s a good idea to check whether the existing Agreement needs to be reworked to the needs of the new shareholders.
Next, you will also need a Share Subscription Agreement. This is a separate contract under which a new shareholder (or the “subscriber”) is issued shares. A Share Subscription Agreement outlines the promise made by a potential shareholder to contribute funds in return for equity in your company. Specifically, it will set out the number of shares to be issued, any vesting conditions, the timing of the share issue and the price of the shares.
In most cases, it would be fine to provide a Share Subscription Letter (which is still legally binding!). But for more sophisticated investors, they might be after a more comprehensive Share Subscription Agreement – a longer form contract with extra protections for both sides.
Finally, you’ll need an IP Assignment Deed. Often, this can be included in the Shareholders Agreement, but it works fine as a separate document too. In any business, it’s important to protect your intellectual property (IP). This includes anything from branding to products and everyday know-hows of your business.
An IP Assignment Deed makes sure that any IP assets are owned by the company and you’re making sure that value is created in the company. You don’t want to later find out that some key IP is individually owned by a shareholder!
What To Take Away…
So we’ve given you a quick lesson on the two types of ways friends and family can help your business get on its feet – debt and equity. But, it’s important to make sure these arrangements are put down in the appropriate legal documents.
Why?
Even if they are your friends and family, it is ultimately a business relationship so it’s always a good idea to make sure you’re both on the same page. Having the right contracts in place will help avoid any disputes about what terms you both agreed to, and can help avoid many awkward situations in the future. This way, both you and your investors will have clarity and confidence in your business relationship.
When your business eventually grows, the last thing you want is a messy situation where you and your shareholders clash because you don’t have any solid agreements in writing.
Raising capital from friends and family the right way means you have a professional business relationship, both sides are kept happy and you can attend those family barbeques without awkward questions.
Still don’t understand what all the different legal documents mean? Or need help getting your capital investments down in writing?
We’re here to help! Our friendly team can set you up with a consultation with one of our corporate lawyers to advise you on your next steps, or we can get started right away on your legal documents.
You can reach our friendly team at 1800 730 617 or drop us a line at team@sprintlaw.com.au for a free, no-obligations chat.
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