7 pitfalls to avoid when taking money from friends and family
StartFast typically works with companies that have raised < $3MM prior to the accelerator so it's fairly common for me to work with founders who are thinking about raising money from "friends and family". These are accredited investors within your personal network, such as the stereotypical rich uncle or successful college friend who are willing to invest in your company during the high-risk early stages.
While this is very common and often essential to a company's survival, I've also seen an unfortunate number of cases result in either stunting the company's growth or putting it in financial jeopardy due to totally avoidable errors on the part of the investor. To make sure this doesn't happen to you, I've outlined some of the most common pitfalls and areas for prospective investors to become familiar with before writing a check.
While there are many potential issues to watch out for with friends and family investors including: how it will effect your relationship, how much value they bring beyond their money, do they have dry powder, etc. these are not our primary concern here. Instead our focus is on the fact that the vast majority of friends and family are what I will call "unsophisticated investors". This DOES NOT mean they aren't intelligent or business savvy by any stretch. In fact this categorizes a number of self-made billionaires! This is referring specifcially to their lack of knowledge and experience with the very specialized nature of investing in early-stage tech companies. An investor's experience on Wall Street, as a family business operator, or CFO can be just as helpful as it can be misleading in this context.
There are really two areas to watch out for when working with unsophisticated investors: 1) things that can bite you when you're raising funding and 2) things the can hurt you after you've taken their money.
What to watch out for while you're fundraising
- Terms: I highly recommend that founders and prospective angel investors become knowledgeable about standard financing deal terms before participating in an investment. A great reference is Brad Feld and Jason Mendelson's book "Venture Deals". Important terms like: preferred stock, vesting of shares, etc. are all covered. The last thing you want is to have your friend hold up their $150K check because they don't understand what a liquidation preference is or worse, start a long negotiation process about terms that don't really matter or aren't standard in early-stage deals.
- Company Valuation: Most experienced business people tend to think about valuation in terms of things like: book value, discounted cash flows, or even having an independent audit done to value the company. If you were to consider the majority of private company valuations, that is typically how it is done but not so when you're considering a high-growth, early-stage, tech company, with almost no physical assets or historical financial data. Valuations are dependent on a huge variety of aspects such as business model, geography, traction, market conditions, etc. Even if an investor is willing to accept a valuation, it's important they understand where it came from and the implications that will have down the line in future financings or an exit event.
- The lack of Intellectual Property: The lack of patents or other intellectual property is something very common to tech startups and yet totally foreign to many unsophisticated investors. Even if a tech company has patents it's very unlikely those patents actually have much impact on the company's valuation at this stage. The reasons behind this could warrant their own blog post (or even book) but, suffice to say this can also become a sticking point for people who don't quite understand how an early-stage company can have value without intellectual property. The bottom line here is that in the age of the Internet, the barrier to entry usually has little to do with IP and more to do with differentiators and competitive road blocks the company can set up as it grows.
- Poor Due Diligence Practices: as Nasir likes to say "they're attempting to make a high risk investment by mitigating risk rather than by maximizing potential returns." Unsophisticated investors will inevitably raise concerns during their due diligence that essentially boil down to a lack of data or predictability. The reality of any early-stage company is that the future is never very clear. Prospective investors needs to accept a reasonable degree uncertainty in this regard and focus more about how to maximize the value of the company than reduce the likelihood of losing their investment.
- Not Taking a Portfolio Perspective: Earlier this year I had a meeting with an up and coming local business person who decided to start angel investing. Despite advice to the contrary he essentially stated that rather than invest in a portfolio of companies he's instead planning to invest in his friend's company when they raise their round. Aside from the fact that the particular company in this story is almost surely a poor investment, this is a common issue with unsophisticated angel investors. They go all-in on a single high risk bet rather than playing the odds and making 10's of investments. It's an almost sure-fire way to lose money as an angel investor and the equivalent of trying to "out smart the market".
What to watch out for after fundraising
- Considering the Need for Future Financings: Most tech companies will raise more than one round of investment. When a company raises future rounds any current shareholder who doesn't at least invest their pro rata share of the new round of capital will face "dilution". In other words, the overall equity percentage that they own of the company will decrease slightly. Dilution tends to cause all sorts of (usually) unnecessary panic and confusion among unsophisticated investors. It's important that they learn it's true implications and to understand where the value increase on their investment actually comes from.
- These are Illiquid Investments: These investments are naturally illiquid until some kind of merger, acquisition, IPO, or change of control type of transaction occurs. That means there are no dividends, there is no interest paid, and investors should not expect to be able to "sell their stake" prior to such an event. Investors need to understand and be comfortable with this fact or founders will inevitably spend an inordinate amount of time managing their investors instead of working on their business.
There are a number of other issues that could be added to this list but the moral of the story is that before you take money from any unsophisticated investors, they need to establish a basic level of sophistication prior to writing a check for everyone's sake. If you have experience with other pitfalls, share your thoughts in the comments below!
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