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.