Be good to Mamma and Mamma (and Papa, uncle Bob and that rich aunt Sheila) will be good to you...
On the topic of friends and family financing and how best to structure those agreements, I know we have written about this before, but I think that a topic this nuanced warrants revisiting.
Ok, so you're entrepreneur Joe, and your dad, mom or that rich aunt, who has always spoiled you silly and thought you were God’s gift to this earth, wants to help you and your start-up, so they give you some money to help you get that start.
Pause…so you got some money from a relative/friend who wants to see you succeed. First question: did they give you the money or was it money for the company? If they wrote you a check (lucky you!) this blog will not apply to you. However, if there was an implicit or explicit understanding that they wanted to lend the company some money, then read on....
Friends and family financing is often easy to come by, albeit in smaller amounts than what an Angel might provide and completely tiny when compared to the amount a VC will usually invest. On the other hand, friends/family investors are in most cases investing in YOU, not the company or the idea per se, and they take relatively little interest in the day-to-day management or operations in the company, even less so than Angels.
Most entrepreneurs are usually quite informal about friends and family financing and the loans and arrangements between the company and friend/family investors are often poorly documented, if at all. Ones that are documented, are usually drawn up are hastily between the parties are usually in the form of a promissory note with some rate of interest.
Most start-up lawyers will usually recommend a convertible promissory note for this type of deal. Using this type of transaction, the simple loan has the potential/upside to turn at a future event, either automatically, or at the option of the lender, into some form of equity of the company at a certain conversion price.
Why not just have them buy equity at some fixed price? Bad Idea - By having any investor buy equity at a fixed price (anything above nominal value) this early in your company’s lifecycle, you are practically putting a stake in the ground in terms of valuation of your stock. Transactions you make in the future may be pegged to that valuation, and can have some dire consequences for the stockholder (in taxes) and the ability of the company to grant shares to attract the right employees (among other things).
Back to the convertible note – what is this future event? Most of the convertible notes that this author has seen or worked with tie the future event to some future financing (be it VCs, Institutional Investors etc.) that results in the company raising $XXX (hopefully there at least seven Xs) through the sale of equities primarily for the purpose of raising capital.
What is this conversion price? Well maybe you think you want to give your family/friend investor the same deal that you gave your VC. Makes sense right? Well think about it a little more and in terms of market price and risk. First, you are offering your family/friend investors market price on your stock, that is the price that your securities are pegged to once this future financing event is completed. Second, in terms of risk, the VCs or the entity that is investing in your company is probably doing so at a later stage of your company’s lifecycle then when you received funding from your relative or friend. Your company then should most probably be in a relatively safer position (though still a high-risk venture) then when you first started. You probably have by this point, assembled a solid team, have a workable product, and are starting to make in-roads into the market. Taking both these points together – do you think it is fair that you reward your family/friend investor the same rate then you would your VC investor, even though technically they (your family/friends) took a greater risk when they loaned you the money? I am guessing you will say probably not. The solution – build in a conversion price into the family and friends note that is at a discount from whatever price that the VC investor pays for their shares. So if a VC is buying shares for a $1/share and you have a conversion feature that has a 10% discount built in, your friend/family note converts into shares where the price of each share is $.90. So they end up getting a little more for their money then the VC does (considering they were the ones who had faith in you when other were laughing at your ideas – I think it sounds like a good deal).
Another important thing to consider, these people trust you, have faith in you and want your company to succeed. You see these people at family holidays and get-togethers. When you’re successful and running a big company do you want to deal with the guilt and more importantly the knowledge that you gave them a raw deal? Take your family/friends note seriously and talk to your start-up lawyer on what makes the most sense for your company.