Raising Capital: Friends, Family, and Stock in the Early Stages

In the last month, we’ve had three founders come to us with questions and problems related to raising money for their early stage start-ups. In the next few installments, we’ll cover critically important issues of executing an early stage raise.

Early Stage: Your Money Plus Sweat Equity

In the early stage of your company, it's likely you will be funded using your own money plus sweat equity. Most investors you'll seek for follow-on rounds will expect that you did both, as it telegraphs that you believe in your product and are willing to risk your time and your money to grow.

If you’re successful with your business and continue moving things forward, at some point you’ll realize that a) you’re running out of personal money to fund your business or b) you need more money than you are willing to invest to take your company to the next level. That’s when friends and family (F&F) money comes into play.

What is F&F Money?

F&F money is getting cash from people you know well. These people are willing to back you because they know you. For them to invest, they don’t need—nor will most of them understand—an in-depth justification for your product.

This has advantages because it allows you to raise money before you may have many details worked out about projected sales volumes and markets or perhaps even have a working prototype.

It also has drawbacks for the exact same reasons—you can fool yourself into believing that your company is great because you raised money. Remember that this money came from people who know you personally and want to support your efforts. They likely don’t have the expertise to fully assess your product or its market viability.

Next and incredibly important is how you raise your F&F money.

F&F Raise Options: Why Not to Sell Stock

Many founders want to sell common stock to raise F&F money. The problem is that this transaction sets the valuation for your company.

Although not intentional, most F&F valuations are set too high because:

1. The founders are very optimistic about their product and company prospects—as they should be!

2. F&F investors are not sophisticated investors, don’t know what’s typical for valuation of companies at this stage, and don’t have the expertise to assess the viability of the product or management team to execute on the plan.

Setting the valuation too high may make it difficult or impossible for you to raise money in the future at a higher valuation than the F&F round, which you need to prevent significant dilution of your ownership.

Key Point: We don’t recommend selling stock at this early stage due to the valuation issue already discussed, the complexity of constructing a stock offering that is exempt from registration rights requirements, and the legal requirements and costs of making such an offering. If you do proceed down this road, these and other factors demand that you work with a corporate/securities attorney who specializes in start-up and ongoing capital raises.

Summary

There are a variety of ways to raise money early for your high-growth start-up. Selling common stock to F&F is not one that we typically recommend.

Next week we’ll cover another option for raising early stage funds.

~~~~~~~~~~~~~~~~~~~~~~~~

What if you’ve already raised early money using common stock? Get in touch to see how we can collaborate with expert counsel to work through the complexities well in advance of your next round raise.

Until next week!

All the best,