Friends and Family vs. Angels - Preseed Financing

by Adarsh Raj Bhatt in August 26th, 2021
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Image credit: Unsplash

Key Takeaways

  • Investment from friends and family is a type of crowdfunding project, where you can collect small amounts of capital from family members and close friends. This kind of investment is given interest-free and the lenders often don’t expect complete payback.
  • Family and friends can invest in your company in two ways -- either as a business loan or as equity funding. Regardless of the exact nature of the round, it is always a good idea to finalize any investment agreement between you and the friend or family member you are getting funding from. This helps keep all parties safe in case your startup runs into any problems.   
  • Angel investors are generally individuals with a high net worth who are known for providing financial support to small businesses and startups. They usually invest in startups in exchange for equity in the company.
  • Angel investors take a lot of risks investing in a startup for equity without any guarantee of future profits. To balance out these risks, angels can include certain clauses in their agreements to better protect their investments. (e.g., anti-dilution clause, control provision, pro-rata rights, etc.)
  • A “friends-and-family” round relies on close relationships, ensures a strong support network, is a source of early-stage money when no experienced investor will invest in you, and offers you the added benefit of not owing a bank (and risk losing whatever you signed off on as collateral).
  • Angel investments also have their benefits. They are less risky than taking out a loan, offer excellent opportunities for invaluable mentorship and high-profile networking, and lend credibility to your portfolio when you’re raising subsequent investment rounds in the future.

How Does Investment in a Friends and Family Round Usually Take Place?

When starting a new venture, one of the early forms of fundraising that founders gravitate toward is from their friends and family. Investment from friends and family is a type of crowdfunding project, where you can collect small amounts of capital from various family members and close friends. This kind of investment is given interest-free and the lenders often don’t expect complete payback. An alternate option is to draft some type of contract for your friends and family, where you can promise repayment with interest, an equity stake in the company, or any other suitable form of return.  

While a friends and family round is a relatively informal approach to fundraising, you should have a formal business plan available when pitching the idea. It doesn’t have to be as complex as it would be in a boardroom, but a few pages to give them a fair idea should be helpful. These pitches are generally referred to as “kitchen table pitches.” Such a pitch depends on creating a strong feeling of trust between you and your lenders -- in this case, your family and friends. Keep the language simple and explain the idea as directly as you can. Once you have captured their attention, show them your abridged business plan. 

Investing your own money into the startup first (before you ask for anyone else’s money) will help as it shows conviction. This is Startup Fundraising 101. It shows that you have already put your neck on the line and are at equal risk as your future investors. You may face some criticism or guidance from family members who have previously been involved in running a business. Listen to their advice as their insights may reveal something important for you.  

Investor rights for friends and family

Funding gained from friends and family comes via informal channels. If the terms of funding have not been made clear in the beginning, there can be a lot of confusion as the business grows, develops, and increases in scale. 

Family and friends can invest in your company in two ways: either as a business loan or as equity funding. 

Taking small business loans from friends and family is a common way for many entrepreneurs to lay the foundation for their companies. This kind of funding generally comes in handy for the pre-seed or seed funding stages of a startup. In many situations, friends-and-family business loans act as a smart bailout option in case things are not proceeding at your startup in the way that you would have hoped. 

Just like any other business loan, a friends-and-family business loan comes with an interest rate. This interest rate must be agreed upon by both parties and an official document should be drafted in this regard. However, there are times where this kind of funding is interest-free due to the informal and intimate nature of the relationship between you and the lenders.   

Another form of funding from family and friends is equity funding. In this situation, you can offer your friends and/or family some equity stake in the company in exchange for the capital invested by them.

There are a few things to keep in mind when promising equity to family and friends. Firstly, owning equity in a company means that one has some decision-making power in the startup. Therefore, be careful of how much equity you are willing to offer, to whom you are offering it, and the potential short- and long-term implications of such a decision. 

Secondly, equity investment is a common engagement that takes place between businesses and investment entities. You must be careful to keep enough equity available to offer to angel investors and venture capitalists in the future.  

Regardless of the exact nature of the friends-and-family round, it is always advisable to finalize an investment agreement between you and the friend or family member that you are getting funding from. This helps keep you and the investor safe in case your startup runs into any problems in the future.

Some examples of potential problems include:

  • Being unable to keep up with repayments
  • Lenders demanding a share of unexpected profits
  • Friends and family interfering with decision-making in your startup

How Does Investment in an Angel Round Usually Take Place?

Angel investors are also known as private investors or seed investors. They are generally individuals with a high net worth who are known for providing financial support to small businesses and startups. They usually invest in startups in exchange for equity in the company. While many angel investors only make a one-time investment in companies, there are other times when the funding can be injected into the startup multiple times to support it during its difficult early stages. 

While venture capitalists invest money owned by a firm or a collective fund, angel investors tend to invest some of their own money which they might have saved over the years. If a startup that’s seed-funded by an angel investor fails, then the investor might not get back any of their investment. Therefore, an angel investor will generally strategize an exit plan like a merger, acquisition, or an initial public offering.

Investor rights for angels 

Angel investors take a lot of risks investing in a startup for equity without any guarantee of future profits. To balance out these risks, angel investors can include certain clauses in their agreements to better protect their investments. 

One of these clauses or rights could be protection against dilution. This clause ensures protection against diluting investors (or belittling them by later selling stocks to individuals at a lower price than what the angel investor paid). The anti-dilution clause makes sure that in case the value of a stock drops, then the investor (who is protected against dilution) gets more shares in an adjusted way such that their initial ownership percentage stake in the startup is not reduced and remains intact. 

Another important angel investor right is the control provision. While the anti-dilution right comes into effect after the value of the company’s stock goes down, the control provision clause comes into play before there are fluctuations in stock. This clause states that a change of control due to a merger, acquisition, or liquidation of assets would need to be approved in advance by the shareholders. This means that since no major change of control can be made without prior investor permission investors will always be aware of all the major changes taking place in your startup. 

One other important right for angels is the pro-rata right. If an investor was involved in the first round of funding and chooses to be included in future rounds too, then a pro-rata clause gives them the right to maintain their initial ownership percentage during future rounds

Pros of Friends and Family Rounds

A friends-and-family round of funding can be a boon in many interesting ways. 

The following are some of the advantages of gaining funding from close relations like one’s family and friends:

Rely on close relationships

Getting funding has many variables that need to be catered to. One of these variables is the type of person from whom you are getting your funding. You can never completely gauge what plans an outside investor might or might not have for your startup. On the other hand, when you’re getting funding from someone whom you have known -- and been close to -- for years, you have the advantage of knowing the kind of person they are. 

They too, will have confidence in you by knowing your strengths, weaknesses, and idiosyncrasies. As a result, they will feel more inclined to invest in your company.  

Strong support network

Your friends and family have more invested in you than just capital. They are emotionally invested in you and your success. They want to see you succeed in your endeavors. They will become part of a strong network of people who will cheer for you from the sidelines and provide support and mentorship as required. Their heart is usually in the right place. Therefore, you can be assured that almost every piece of advice you gain from this network will be provided with the positive intent to benefit you and your startup.   

Early-stage money

Early-stage startups don’t always see a lot of individuals approaching them to provide funding. At this stage, the startup may just be in the stage of accumulating the necessary resources to begin the process of producing their product or providing their services. Serious investors generally feel nervous about funding a business at such an early stage. In the case of family and friends, however, their confidence additionally comes from their relationship with you rather than solely from the current stage of your startup. They feel more comfortable lending you money than “outside” investing entities would. 

Don’t owe a bank

If family and friends are funding you, then you are not under any pressure to pay lenders (such as a bank) back within a set period of time. Also, you haven’t pledged any kind of asset as collateral, so there is no danger of anything being taken away from you -- which is what tends to happen with (secured) bank loans. This makes family and friends funding a relatively risk-free and convenient option for startups.   

Pros of Angel Rounds

The following are some of the advantages of being funded by angel investors:

Less risky than bank loans

This is one of the greatest advantages of being funded by an angel investor. When taking a business loan from a bank, you are expected to pay back the bank the principal amount along with interest within the stipulated period. Angel investors do not need to be paid back, as they fund your startup in exchange for equity. They take a risk of waiting for your startup to make a significant profit so that they can sell their equity at a beneficial point.   

Mentorship and networking

Angel investors are generally high-net-worth individuals with large sums of money and years of business and investment experience. Once they invest in a startup, they also tend to impart some solid technical and managerial knowledge to the founders. They do so without charging the founders because if the business makes a profit, so do the angels. 

Since angels normally have at least a few years of experience in business, they have access to a great network of friendly individuals who can help scale up your startup. 

Better Portfolio

Angel investors are part of a large network that comprises individual and institutional investors. When your startup makes some progress and you reach out to other investment options, the name of these angel investors on your portfolio will instill confidence in future investors who are part of the same network as the angels. 

Cons of Friends and Family investment

While the pros of using friends-and-family investment are very compelling, some disadvantages must also be taken into consideration. 

Relationships interfere with business

It is generally advised by many professionals to keep personal and business lives separate. People take years to develop strong, lasting, and often complicated relationships with friends and other family members; these relations are essential for our fruitful existence in society. However, if two individuals who are related in this way have strong differences of opinions in their workplace, it may bleed into their personal life, creating unnecessary tension. 

Close Critics

While your family members normally act as your support system, oftentimes they will feel like they’re at greater liberty than others to criticize the way you run your startup (since they are close to you, after all). In rare situations, they will believe that a shift of power is necessary and try to take the wheel and run the startup themselves. This will certainly create a lot of friction between you and your relatives and hamper your peace of mind.  

Investors may lack proper knowledge

In your family circle, there will be a few individuals who know how startups work and the actual information required before investing in one. These are the investors to aim for. Others, however, will be individuals investing capital just because they know you or care for you. They will lack the knowledge to understand the necessary risk and may end up investing their life savings without much thought. 

None of this helps you. Knowledgeable investors are great for you as they can offer constructive criticism even when they choose to not invest in you. You can then incorporate some of their insights into your strategy and emerge as a better team, product, and startup overall. 

Cons of Angel investments

While there are many advantages of doing business with an angel investor, there are certain disadvantages to keep an eye out for:

Loss of equity

Angel investors are looking to invest in startups that will make them large profits. Therefore, they invest in startups in exchange for equity which they can sell later. You must be careful of how much equity you promise to the angel investor, as it becomes an essential source of leverage in later years. In case you end up promising, say, 50% of the equity in haste, you may suffer when trying to secure further investment over the years. 

Pressure for high returns

Because angel investors make their money based on the growth and performance of your startup, they may have high expectations from you. Sometimes they are expecting close to 10 times the return of what they have invested. This may exert undue pressure on your team. 

Loss of control

As equity owners, angel investors receive the right to have their say in the developments of your startup. While this is beneficial when they’re acting as a great source of knowledge, it could become problematic if they try to take over control of your startup for their own gains or even if they try to micromanage your day-to-day operations. 

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