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Category: Convertible Notes

The Importance of “Friends and Family” Rounds

When people in startup ecosystems speak of “friends and family” rounds, they are typically referring to a very early round of financing – often the first round – of a startup in which all the people putting in money have very close, personal ties to the founders; which makes them more willing to take on a level of risk that a true investor may not.

Because so much of the wealth circulating in Silicon Valley was created in tech, “angels” in SV tend to be more more risk-tolerant relative to angels elsewhere in the country. They trust their ability to judge vision and team, independent of traction, and are therefore willing to invest much earlier. In other parts of the country, however, there is far less of that truly angelic angel money.  Much of the wealth available outside of SV for angel investment originated in non-tech industries, and the investors are therefore more conservative in their risk tolerance; often expecting more traction and milestones before they’ll invest.

That means that in ecosystems like Colorado, friends and family rounds are a vital part of helping entrepreneurs jumpstart their companies.  The most common F&F structure that we see is a convertible note, with a discount on a future funding round. The note should have a very long maturity date, like 3 years.

We advise that you avoid placing a valuation/valuation cap in a F&F note (most angel/seed convertible notes have valuation caps), however, because friends and family investors usually aren’t experienced enough to properly value the company. If you place it too high, you can create unrealistic expectations for the future. If you place it too low, it will “anchor” the valuation expectations of future investors, weighing the valuation down.

While we advise against putting valuation caps in F&F notes, we will include a provision giving your friends and family investors a discount (often 20%) on the future valuation or valuation cap that your angels/seed investors get. Say, for example, a year after your F&F round you do an angel/seed round at a $5 million valuation cap in a convertible note. This provision will amend your F&F notes to then give them a $4 million valuation cap; with the discount being the reward for additional risk they took on. And if your seed round is an equity round, the F&F note will simply convert into the seed equity, at a $4 million valuation.

This dual discount structure ensures that, whatever investment structure your seed investors get, your friends and family end up with the best deal, which they deserve because they invested the earliest.

Important point: There’s a common misconception among first-time founders that friends and family investors do not need to be accredited investors. This is incorrect. There is no such thing as a “Friends and Family exemption” from securities laws. To avoid serious problems down the road, startups expecting to eventually take on more experienced, institutional investors should steer clear of all non-accredited investment and only take money from people, friends and family or otherwise, who have sufficient income or assets to qualify as accredited investors.

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Colorado startup seed financing structures.

Background reading:

In terms of how a typical emerging tech company (startup) raises seed capital, there are 3 options that from our experience make up 95+% of rounds: Equity (Preferred Stock), Convertible Notes, and SAFEs (Simple Agreement for Future Equity).

If you want a deeper dive into their pluses and minuses, read the above-linked posts. At a high-level, equity (stock) is more complex to negotiate, draft, and close, but has the benefit of greater certainty. Larger rounds tend to be closed as equity. “Seed equity” is a subset of equity financing using slimmed down, very template-ized documentation that can be closed much more quickly (with lower legal fees) than a full VC-style equity round. When rounds below $1.5-2 million are to be closed as an equity round, we see Seed Equity being increasingly utilized as an option.

Apart from equity, there are convertible securities, with convertible notes and SAFEs being the 2 dominant forms. Convertible securities are much easier to draft (lower fees) because they defer a lot of the hard issues/negotiations to the future.  But the cost is more uncertainty, and also somewhat more dilution. 

A convertible note is effectively a debt instrument that intends to convert into equity in the future, when a larger financing occurs. It has a maturity date (like a loan) that sets a deadline on the company reaching that milestone financing, or else a discussion/re-negotiation with the investors needs to happen.

SAFEs are basically convertible notes without a maturity date. They also convert into equity in the future, but there is no “deadline” of a maturity date, which is much more company favorable, and investor unfavorable.

A recent survey of seed financing structures reveals that in California, where the volume and density of seed investment (and competition among investors) is magnitudes higher than the rest of the country, SAFEs are well on their way to becoming a dominant seed round instrument. SAFEs were originally created by Y Combinator.

A key takeaway from that survey, and which I’ve emphasized several times before, is that entrepreneurs in Colorado, Texas, and other ecosystems should be very careful to not extrapolate trends in Silicon Valley into their companies, because the norms of their local investor community are likely different. Among convertible security seed rounds, convertible notes are far more preferred by seed investors here than SAFEs.

I don’t represent a single tech investor, for reasons I’ve written about in How to Avoid “Captive” Company Counsel, so I can speak with total impartiality in saying that SAFEs are extremely company friendly to the point of being somewhat ridiculous in many cases.

The “deal” between an investor and company in a convertible note round is that the investor will accept fewer rights upfront (which is risky for them), but the maturity date and debt aspect of the investment provides them some protection. A SAFE basically tells an investor to accept all of those downsides (fewer rights upfront), and yet let go of that protection. Hope for the best.

It’s no surprise that SAFEs came from YC. Already within California, there is much more competition among investors to get into the top startup rounds, so terms in general are more company friendly. YC is the elite of Silicon Valley in many respects, so YC companies by default are able to dictate terms much more easily to investors than a typical startup.

Still, as the data shows, SAFE rounds outside of Silicon Valley do happen. We certainly close them. But the core point here is to not get too hung up on them. We too often see founders try starting out with a SAFE, and then have to change course mid-round (which is more costly) because a serious investor gave them a reality check. Better to focus on convertible notes, if you’re doing a convertible round. As long as the maturity date is far off enough (2-3 years), get the money and move forward.

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