Attracting investors can be incredibly difficult in the early days of a company. For this reason, some founders choose to seek pre-seed funding with the help of friends and family.
A friends and family round of funding is when founders seek investment from their personal networks. This round of funding is considerably less formal than rounds involving professional investors because of the company’s virtually nonexistent performance reports and revenue streams.
Additionally, the investment compensation for a friends and family round of funding is typically lower than rounds involving professional investors. The low investment compensation and terms may be attributed to friends' and families’ personal motivations for investing: Your loved ones want you to succeed and are often more interested in helping you achieve your dreams than seeking a big return, as an investor would.
[Read more: Finding Seed Funding for Your Startup]
Tips for raising a friends and family round of funding
Consider your company’s valuation
Placing a realistic valuation on a pre-seed company can be difficult due to a nonexistent or unreliable revenue stream. The best way to create a valuation for a pre-seed company is by comparing it to an existing company on your own or by utilizing a third-party agency. The comparison may not be perfect, but it will act as a jumping-off point.
A friends and family round of funding is informal, meaning your personal network likely does not care about the actual valuation. However, they do want to see you put the effort in and see you’re serious about your business idea.
Create a detailed business plan
No matter who it is, investors want to understand the inner workings of the company. Creating a detailed business plan is a valuable exercise that extends past the funding stage. First, determine the length of the plan. The further out the plan forecasts, the more unreliable it becomes. Consider detailing the next six months, and when in doubt, be conservative about expenses and revenue. It’s always better to undersell an idea to investors — especially when the investors are people you care about, like friends and family.
A friends and family round of funding is informal, meaning your personal network likely does not care about the actual valuation. However, they do want to see you put the effort in and see you’re serious about your business idea.
Understand the different types of funding
There are three ways your personal network can invest in your company:
- Loans:This investment will be repaid over time and may include interest.
- Gifts: This investment does not need to be paid back, and the individual giving the gift does not receive compensation.
- Equity: In exchange for investment, a piece of the company is given as compensation, effectively becoming a business partner.
[Read more: How to Fund Your Business]
Write and communicate the terms and repayment plans
Once your friends and family have settled on an investment type, nail down the finer items of the arrangement. Discuss repayment plans and interest rates for loans, create term sheets for equity investments, and make formal agreements for gifts.
Properly recording and communicating the finer points of investment is beneficial for both parties. A founder needs to track fundraising to avoid over-diluting. Investors also need to understand and document their risk involvement. To avoid errors and future disagreements, consider consulting a lawyer who specializes in business or startups.
[Read more: 3 Investors Demystify Why Some Startups Win Funding Windfalls]
Pitch to trusted loved ones
Practice makes perfect. You will likely not secure all your pre-seed funding from just one friend or family member and will have to pitch your business plan to a lot of individuals in your personal network.
Consider starting with your close family members, or the individuals who will most likely want to invest in your company. An extra benefit of pitching to family first is that blunders and errors will be easily forgiven.
Next, branch out to close friends. This group might consist of childhood friends, former classmates, old colleagues, and mentors. The best way to compile this list is by running through your phone’s contacts.
Finally, pitch to work colleagues and friends of friends. These individuals will likely have the least incentive to invest in your company — but at this stage, your investment pitch should be well-polished.
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