Coach Mike: The Four Rules of Raising a Friends & Family Round

Okay, hello everyone, and we're live here for another Coach Mike episode. I'm Drew Zayas, your producer, joined by the one and only Mike Supravici. Mike, why don't you introduce yourself?

Hello everyone. For those of you who are just tuning in your first time, my name's Mike. I lead the Alumni Success Group here at the Founder Institute. And my role and our team's role is to basically help our companies scale, and we're with our companies basically for the rest of their lives. Prior to doing this, I was an entrepreneur as well, raised money, kind of went through pretty much all the things that you might have gone through. And now, because I do have insights from such a large portfolio of over 3,600 companies, I've been able to see some things that work and some things that don't. And I'm basically here to share my thoughts on that.

Awesome. And today we're going to be picking your mind here on friends and family round.

Yes.

The kind of first stage of raising capital where a lot of people start and where a lot of things could potentially go wrong.

Yes.

So, and if you're not familiar with this format, it's basically Mike dropping knowledge on us So let's get ready to roll. First off, right off the gate, how do you think about friends and family round? What context do you think about this in? Is this raising a traditional round? How do you pitch friends and family? I have a lot of questions.

Yeah. So yeah, there's a lot there. Maybe, maybe we can start at the top. What is friends and family? The name is pretty self-explanatory, but it's basically people in your inner circle. Generally people that maybe don't invest professionally in startups, although some people may have friends that do that. But in general, you know, these are— a lot of these folks are, you know, like your parents or something like that, or, you know, a really good friend. And then, so that's what basically a friends and family— so you're going to your friends and asking them basically to invest in your business. Now, you know, should you do that is also an interesting question that comes up a lot, that we get a lot. And this one's a really difficult one for me to say yes or no to. Bottom line is this: you are building a startup. A startup is a business. A business is a collection of people and contracts at its core. And people are unpredictable. That's why the success rates of businesses tends to be extremely low. And so if you— so what I'm getting at is that the most likely scenario with your startup is that you are going to lose all of your friends' money. That's the most likely scenario. And if you're okay with that, if you're comfortable with that, if your friends are comfortable with losing all their money, if you can— if you, you know, for those of you that are here in the United States, if you're still comfortable hanging out with your, you know, aunt or your uncle at Thanksgiving after you lost their money, then I say go for it, right? If you're not personally comfortable with that, then yeah, it's better to just try to not go down that route, right? Same thing with family and things like that, your friends, all that, right? You know, these relationships might be more important to you than potentially the business, and if it can damage them, then I would just say be careful with that, right? One way to manage this is to just be really clear and transparent and very educational about what your friend is gonna get into. So let them know the most likely scenario is I am going to lose all of your money. So if you give me $25,000 right now, just— you should write that this off like, you know, a lottery ticket, a $25,000 lottery ticket, a very expensive lottery ticket. And, you know, in the unlikely scenario that we succeed, then maybe you will be able to get a very good return on that, you know, possibly double, triple, possibly 10x. But the most likely scenario is that you're going to lose all your money. So you need to go into that and understanding that. And if you're comfortable with that and you wanna kind of join our mission because you believe in my vision, then let's go ahead and kind of move on and go for it.

That seems like a really difficult thing to do because whenever, you know, as founders, when you're approaching any sort of investor or somebody who wants to invest, you feel inclined to just present all the positives of that potential investment. It's almost like counterintuitive to say, oh, I'm probably gonna fail. How do you keep their faith in your idea when you're telling them that?

Well, I think, look, I get, I get that it's hard, but you have to be very matter-of-fact about the situation, right? We're gonna maybe cover in a call a little bit later about how to kind of like position your business, how to pitch them and all that. But like, you basically have to talk about obviously the vision and why you think that this will be a success. But at the same time, you have to you know, countered out with a lot of realism. And if you don't do this, you're going to be in a very difficult situation with people that are really close to you and that you care about because there were misaligned expectations and you don't have a choice here. So I, you know, I know this is difficult, but everything about entrepreneurship is difficult. This is just one of the difficult things that's on the list of difficult things that you're going to have to deal with. So you're gonna have to be transparent, right? Very transparent. Say, look, the most likely scenario, most startups fail, okay? And the most likely scenario here is that I'm gonna lose all of your money. If you're comfortable with me losing all of your money and you're not gonna stress over me losing all of your money, then let's proceed. If you are uncomfortable, so then let's not do it. So just think about that and then we can have another conversation after you've given it some thought.

Gotcha. Yeah, so, uh, when should you start raising an inside round, or I guess friends and family rounds, what we're calling here, if you choose to do that? Like, at what stage should you start that process?

Well, I think taking a step back, at a fundamental level, you have to, you have to be at a point where you've done enough validation of the idea of the business to where, number one, you you believe that you should incorporate a business around this. So that's step number 1. So you've already made that investment into the business. And number 2, where you actually see a viable path to this business, right? Because if you're not confident in it, then you're gonna have a really difficult time convincing others that they should do an investment in this highly risky business that will most likely fail, right? So what you have to do is have like a big picture perspective that look, If this works, this is going to be a very large business, right? Otherwise, just the economics don't work for your friends either, right? Like, if, if you're building a small business, it's just difficult for, for people to maybe get 5, 10 times their money back on an investment like this. That's— this is if you succeed. And why do you need that kind of return? Well, because you're hedging against the most likely scenario, which is in 9 out of 10 cases you will fail, right? So you have to kind of counter that with a really high potential. Otherwise there's no alignment. And that's okay. That may mean that you just don't raise money. That means that maybe you build a business off of revenue, which is how most businesses are being built, and maybe use some bank loans and things like that eventually to build it. But if you're gonna go down this path where you're gonna start raising money from like investors, you have kind of essentially changed like the dynamics of the relationship. And there has to be alignment between your expectations and the expectations of the potential investor.

Gotcha. So I have a couple questions diving into like what a friends and family round looks like. Should you treat this like a normal investment round in the way that you approach these investors?

Yeah, so, so, um, let me kind of COVID something that I think is really important. So for the audience, that's listening to this that's in the United States, you have to deal with this whole idea of accredited investor status. For those of you that are in other places like Canada and things like that, this is a non-issue. But basically in the United States, there was a lot of legislation passed in the '20s when basically like the stock market, you know, kind of took a turn for the worse and a lot of people like lost a lot of money. So the government, to protect people, basically said that you have to have a certain amount of income in order for you to be able to take these extremely risky bets. And you can go up and Google accredited investor status, but basically the person that's investing in your business has to make a decent amount of money. Like, I think it's $250,000 or more a year, because at that point you can argue that, at least from the government's perspective— I'm not saying that this is right or wrong— You know, that if a person that makes that kind of money lose $10,000, maybe they won't worry about it, won't do a lot of harm and affect them in a difficult way. And so because of this, if your friends and family are not accredited investors, it's basically— it's not basically, it is illegal for them to invest in your business, all right? They should not be investing in your company. If, you know, they fit that, then they should. So then the question is, well, how do you get money from people that are not in this accredited investor status? Well, one workaround around this, one that a lot of founders will use, is that they'll basically have the investor, the friend, whatever, write a personal loan to the founder. and oftentimes it's backed by the company or guaranteed by the company or something like that. And, you know, you can work with lawyers on kind of how to do this, but this is something that's very important because if you don't kind of follow this, it can potentially open you up to liability. So if you're in the United States, take a look at that and understand accredited investor status. The way you, you know, the question, the way this question was framed initially is like, is this like a regular financing round and things like that? It's not, right? Because it's your friends. And so the psychology of it, the way you put the, the way you talk about it, everything about it is different, right? These are usually your friends or your family. They want you to succeed. So they're going to be more or less betting on you personally, you know. And this is so, it's a very different dynamic that happens there. And then you have the culmination with that, with them not being sophisticated, like they maybe don't understand or know how startup investing works and what the risks are and things like that. So as a founder, you know, you need to do a lot more work, extra work to educate the potential investor on what they're investing in and how this works. So, so you're going to have to educate yourself really well on financing structures. And I'm sure we'll probably cover this later and what the impact of those are going to be. And, you know, in the best-case scenario, or what this would look like as far as a potential return, 'cause you might get these types of questions and things like that, right? So it is different, even though the underlying structure of how you actually bring the money into your company is more or less the same.

Gotcha, so beyond managing expectations of these friends and family round investors, "how do you make sure that you don't lose your friends out of all of this? It seems like the relationship aspect of this is kind of tenuous. How do you keep your friends, Mike?" Uh, I don't know, see a therapist?

No, I don't, I don't know. I mean, that's— look, the best approaches I've seen is where the founder brings their friends kind of on this mission. And keeps them in the loop of how things are going, you know, and is proactive in letting them know how things are going and sending a reg— like a regular update to their friends and family people so that, you know, that they're kind of part of this mission. And good or bad, right, that's how you manage that. And when things do go south, you basically let people know that This isn't, you know, this is not working and these are the reasons why. And, you know, maybe your friends could help you in those situations. Most likely they might just not have the expertise to do so, but at least knowing what's going on is really helpful.

So like investor updates from a really, really early point in time then?

Yeah, I would do like a special friends and family update on this one because I would actually I would talk about like, you know, different things because you look, you know, your friends, right? And you kind of know like the things that are interested in, they're interested in. So some of the things that you talk about, you should, you know, you should put in this, in this email so they know what's going on with you. You know, the worst thing you can do is take their money and not communicate with them until like the next year's Thanksgiving dinner, right? That's bad. And don't do that, right? So just be in touch with them. And just be kind of transparent about how things are going, you know. And that's, again, that's one of the, the things that you're going to have to like manage, and as you— and one of the things that you're going to have to think through if that's what you want to do, right? Like, do you want to be on a, uh, having conversations on a regular basis with like, you know, your, your aunt or your uncle or something about this business as the business progresses? And you you know, having to educate them on how things are going. If you foresee that being a problem, then it's probably not a good idea to try to raise money from them, right? Because once you introduce money into relationships, the relationships get pretty challenging. And so you have to be able to kind of overcome that challenge by over-communicating how things are going.

Yeah, find your cool uncle or aunt.

Well, I mean, yeah, but once money comes in, that cool uncle could turn into not cool pretty quickly. If you don't manage like expectations. And family dynamics are tough, right? And so, I mean, this is more like a judgment call based on kind of your personal relationships with these, with these folks. Yeah.

And they probably also want to know like how their money is being spent as well. So maybe that's something founders can—

Yeah, so that, that's, that totally depends on the person. You know, you may have, um, a friend who's They're a CPA, that's what they do for a living, they're like an accountant, so they're gonna for sure ask you a lot of questions about that kind of stuff, but you may have a friend that does other things for a living and I don't know, they might not care as much, right? And so just something to think about as you discuss this with them.

So I've seen some people be very public about the money that they've raised from friends and family and like put it on Crunchbase and everything else. Would you recommend doing that as like a strategy to showcase where your company's at?

Um, it doesn't really add that much value because the way you want to think about it is, I mean, the only reason people do that is, is generally to kind of signal something to the market. The fact that you were able to convince your, your dad to invest in you personally is not really signaling much because, like, as I said before, they're more or less just investing in your success and wanting you to be successful. And so it's not like it's gonna open up more doors or make it easier for you to go and raise more money in the future from professional investors or anything like that. So there's almost like no value really to doing that. You're almost better off just being stealth about it and not really discussing it. You know, obviously with employees and things like that, you can do that if you want, but on Crunchbase, it's not worth it. So I wouldn't really do that. Usually that's the financing announcements in general, since you kind of brought this up, there's usually a reason for those announcements, right? Like the company wants to use that in general to recruit more employees because they just raised a Series A, for example. So that's a very good reason to kind of try to use that for announcements. Otherwise, it's just not that interesting or helpful.

Gotcha. So rewinding maybe just one step. So right when you're trying to land these investors, I kind of want to dive into how to close friends and family in a way that you know, you both feel good about. Could you speak on that for a little?

Yeah, so the first thing that you want to do, as I said, is really educate yourself well with, like, the terms of the round, because you're going to be the one setting the terms in this situation because you're the one that's going to have to educate them on how this works. And so first step, number one, read about various financing structures and have your lawyer review whatever terms you decide on. Now, in terms of like order of terms of how you should think about this, generally a SAFE is the best for the founder at this stage. Second would be a convertible note, and a third would be like a straight equity. You know, also just from a legal perspective, both a SAFE and a convertible note are significantly less expensive. It also helps you kind of punt the valuation talk that's really difficult to have because it's such an early business. Til later down the line. And so then once you decide on that framework, let's say you decide to do a SAFE, then what you want to do is get yourself familiar with all the different things like what is a cap and what's a discount and how, you know, what is a good cap for like my business right now, how much do I want my investors to win, right? Because you could, since you're driving the terms, you could technically create really good terms for yourself personally, but maybe not as good for the friends and family. So those are like all discussions that you have to have, and there's like no right answers. Like, oh, if I just go A B C— no, this is something you kind of have to like think through a little bit, right? And kind of really understand the terminology of it. Once you've come up with these terms, right, then what you want to do is have a conversation with your friends or your family about this, and you say, look, this is— we're going to do a SAFE, we're going to do a cap of $3 million on this, we're going to do a 20% discount as well. This is how a SAFE works, right? It's a SAFE, is a simple agreement for future equity, blah blah blah blah blah, and you go into like all the details about how this would work, uh, and then you basically ask them if they think this is a fair agreement, right? And then you kind Listen to them and say, what do they, you know, maybe they'll give you some feedback, or maybe they just don't, are not in a position to give you any sort of feedback. And they say, okay, okay, I'm ready to do it. Usually that's how it works out, honestly, because a lot of the friends and family folks are just not like sophisticated enough to like have a sophisticated negotiation with you over this. Some may be, right, but in general that's not how it goes. And so At that point, let's say they agree to your terms, then you have your lawyer draft the terms to ensure that. And what your lawyer will do is they'll put in, for those in the United States, is an accredited investor questionnaire. If they don't, make sure that they do it. And that basically makes the investor sign off that they are accredited, right? That way, like, you don't have any risk to the business, right? That's how you essentially would close the deal. But the best closes generally happen when you have like an honest conversation like, hey, do you think that the, you know, do you think this is fair? It's like, oh, it sounds about right. I just, I don't really understand what the point is of this like discount or how does this discount work? And you kind of educate people and then, you know, maybe they'll push back against some with some other terminology or some other terms and things like that. Last thing I'm gonna say about this, and this is very, very important. Sometimes friends and family that are not that sophisticated but sometimes think they are more sophisticated than they are about this end up wanting to add random non-standard style terms into your deal. Do not do a deal like this because when you add these random terms that may make sense at the time for the person, you're essentially, will make it more difficult and sometimes impossible for you to raise more money, right? If your uncle says like, yeah, I'll do it, but I just never wanna be diluted ever. Like if you raise another round, I've seen this by the way, this kind of brought this up where you have like an uncle that says, I want 20% of the business, but it's going to be 20% for the rest of the business, right? Like, you know, that's not how it works, right? If another investor comes in and invests, they're going to dilute them down to probably 15% or 12% or whatever it is.

And all of a sudden the founder has no equity.

Yeah, that too. But more importantly, like, if you have this clause, you will not be able to raise more money. And most investors are not going to like want to even get involved with that deal because it's much easier for them to look for a new deal than to try to get to you to convince your uncle to like remove that clause from the agreement. And it creates a big headache for you 'cause, you know, if you do go out to try to go raise money, before you even go and talk to investors, you have to go out and convince your uncle to take that out because otherwise the company's unfundable, right? And so the easy way to manage this is for you to manage the drafting process, right? Have your lawyers kind of like do all the drafting of the documents. So that's the easy thing. And use like standard off-the-shelf documents like a SAFE agreement, which is available, convertible notes also available. And just keep them as vanilla as you possibly can.

So you kind of mentioned that there's some difference in how these friends and family rounds are done based on where your location is. You talked about how in the US we have our accredited investor status. And I know that your expertise is in the US, but We do have a lot of listeners outside the US, and for you folks, how is this different for them? Like, especially when you're trying to close friends and family rounds across international borders, does that change the equation?

Yeah, I mean, well, a lot of that's going to be driven by like the incorporation of the company and how it's incorporated. You know, again, if you're If you're in the US, you'd need to be a Delaware C-Corp. If you're any other type of entity, it's going to be very challenging, if not almost impossible, for you to raise more money from investors. But there's similar things happening across the world. So you just want to make sure that that's well taken care of. Most other countries don't have accredited investor status, so that's something to kind of you know, just kind of think about as well. So that's great. But the process that I've outlined still remains because it is your friend. And your friend, if your friend's gonna give you $5,000 and you lose their $5,000, they're gonna be angry. That person might not be your friend anymore. That's something you're gonna have to deal with. So, you know, you know, the thing that you have to do is that there's no way for you to keep a lawyer out of this. You have to eventually bring lawyers to kind of get this done, to draft all the documents to make this happen. But you first need to educate yourself on all the laws that are in your current— where your company's incorporated, in what country and things like that, and then have your lawyer draft the agreements based on that jurisdiction.

Gotcha. Okay, Mike, one more question before we go. How do I know that this is the right option for me? How do I know that I shouldn't just bootstrap and that I need to raise a friends and family round?

Well, they're not mutually exclusive. I actually think that bootstrapping is a really good idea for pretty much most companies. So you should bootstrap as much as you can. You know, the way, the way you look at it is, you know your friends better than anybody, and you know their tendencies, you know. And you know if this is a potentially like good fit or not. You know, there's, there's two perspectives on this, right? Doing— there's the perspective where it's like doing business with— you just don't do business with family, right? And that's a very legitimate one because whenever you do business with family, things get very complicated and very difficult to manage. And oftentimes it causes families to get broken apart. Right? And so it's a very good law, or rule I should say, that could be applied, and I would bet that in a lot of cases it's a very, it's for most people that could probably work really well. However, if you do have a really good relationship with people and you are transparent, you can go to the second route, which is just absolute like raw transparency about what these folks are getting into, right? And what's important to them, right? You know, what's gonna happen, what happens in a lot of friends and family rounds is that a lot of friends and family members are like, well, I want in, I want into this, right? Like, they actually want in, and they might actually be upset at you for not letting them in, which is kind of an interesting thing. But what you have to do is just be extremely transparent about this. And the only way you can actually be transparent about this is to be extremely educated about how financing works. And the good thing about that is, is that this is all kind of like available online. Like, you know, you can download a SAFE, you can read it, probably have to read it like 5 times because it's got like a lot of legalese in there, but it's still something you can do, right? You could— there's a lot of information about how that works. And, um, just be very realistic about What's the most likely scenario with regards to the business? Which is that in most cases, most businesses don't make it or don't make money for investors, right? That's just the reality of it. However, in the unlikely scenario that you may succeed, then the investor will make a lot of money, right? So if you can kind of position it like I just did right now and people still wanna invest in you, then that's a pretty good litmus test people know what they're kind of getting into. Uh, that's, that's what I would say with that.

Okay, so do your research, be transparent, manage expectations.

Exactly.

And don't sign bad terms.

Don't sign bad terms, otherwise you will not get funded.

All right, well, thank you so much for joining us, Mike. I hope to have you on in the future, man.

Awesome, thank you. Bye.

Thanks for listening to the Founder Insight podcast. For more episodes, visit fi.co/podcast.

Thanks.