Written by CMG News Contributor, Doug Carleton
Venture capitalists frequently talk about the capital stack. This refers to something like a stack of blocks that make up the stages of investment money that go into startup companies. At the bottom is the founder's initial investment of personal funds. As an aside, without this personal investment from a founder, banks would be even more unlikely to lend to a new venture because they generally don’t like startups anyway. This is because of the high risk, and very much the same for venture capitalists.
The next block up the stack, the one we’re discussing here, is investment from family and friends. This is often an important source of additional investment capital to enable a new company to get started. It could come from a family member or a friend of the founder's family who thinks the idea for the new company has merit and wants to help it get off the ground. It can sometimes mean the difference between having adequate funds to start a company or not.
There are certain advantages to investment from family and friends. If for some reason, a bank loan is not available, money from family and/or friends would likely be cheaper even with interest rates as low as they are now. Terms of family and friends' investments can be very flexible or just based on the founder’s good faith to return the investment, maybe even with some premium. The obvious potential disadvantage is that if the company fails and the investment is lost, conversation around the family dinner table could be a bit strained. But it’s not that difficult to take some of the potential trauma out of the investors losing their investment unexpectedly.
In 1934 the Securities and Exchange Commission was created because widespread fraud, insider trading, market manipulation, and other abuses were common at that time. The SEC expected investors to get “full and fair” disclosure of anything other than publicly available information about companies whose stocks investors were buying.
Full and fair disclosure should be a good guide for seeking investment from friends and family investors as well. And the simplest and safest way to provide it is to put it in writing. No matter who the investor is, any investment should be considered as an arms-length transaction as though you did not know the investor. The terms of the investment should be clearly defined, and unless it is a larger amount of money and a more complicated type of investment, it doesn’t have to be complicated. By specifying the terms of your offering, it also shows that you are starting off doing business in a professional manner, and it’s possible that somewhere down the line a lender or investor might want to know where your initial investment came from and on what terms. So if you have a written agreement that you can show this could quickly enhance your credibility with whoever you are talking to. Friends and family investment can be critically important to a new venture but make sure you treat it as seriously as it would be if it was coming from an outside investor who didn’t know you.
This blog entry is a slightly edited excerpt from Doug Carleton's 'The Daily Life Of A Small Business Owner' series. Doug was a mentor with SCORE, Startup Virginia, and Lighthouse Labs, and has 25+ years of experience in small business finance including 12 years in SBA lending. To contact Doug directly, please email him at firstname.lastname@example.org.