Friends, family, fools?
Wednesday, May 7, 2008/
Getting start-up capital from friends and family sounds like a good idea, but it’s fraught with danger. DORON BEN-MEIR
By Doron Ben-Meir
You’ve decided that it’s worth the punt – you’re going to start a new and exciting business built around an innovative idea that has the potential to be really big.
It’s still early days. You need funding for infrastructure or the development of a prototype product/system and the house is already mortgaged. So how do you get started?
There are a number of options, but often entrepreneurs in this situation turn to their immediate family and friends to join with them as seed investors to kick start the enterprise. Their local solicitor or accountant gives advice on the best corporate structure and away they go.
Last week I saw a manufacturing business whose founder was a doctor and he was able to secure investment from a number of colleagues and other professionals.
He ended up with a large share register (more than 50 shareholders) with poor alignment of interests, unrealistic valuation expectations and a complex corporate structure invented by local solicitors/accountants that thought it was clever to establish a network of companies and trusts.
This is quite typical of what is sometimes disparagingly called the friends, family and fools (FFF) round of funding. Why fools? Well…
More often than not, such investors have no experience in fast growing start-up companies, they don’t have a full appreciation of the risks and they rarely (if ever) have the market or business intelligence to understand underpinning value propositions or future capital requirements. Worse still, their valuation expectations are often set by optimistic projections and misinterpretations of success stories in the media.
Sometimes these sorts of issues are enough to kill a deal for professional investors, as aligning interests and setting realistic expectations becomes too difficult.
Of course, exceptions prove the rule. If the business is screamingly successful none of this will matter and you will be worshipped by all.
If it turns out to be harder than you thought, requiring more money and time, this is a great way to cause family friction and turn friends into enemies!
In general, if you can avoid an FFF round, you should.
If you have no option, here are some guiding principles to keep in mind:-
- Consult with professional investors to understand their expectations of prospective deals before you take FFF investments. You may also get suggestions on preferred structures for the FFF round.
- Make sure you have a quality shareholders agreement that aligns investor interests and enshrines simple decision making processes. Ideally, find an experienced lawyer with venture capital/private equity deal experience to guide you through this process.
- Keep your corporate structure simple. Professional investors will typically want shares in the company that owns the intellectual property of the business.
- Do your best to inform investors of the high risk nature of their investment and that the valuation of the company will not necessarily go up in future funding rounds.
Doron Ben-Meir has been an active venture capital manager for the last eight years. He founded Prescient Venture Capital and prior to that was a consulting investment director of Momentum Funds Management. He was a serial entrepreneur over a 12 year period, co-founding five new technology based businesses.
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