LEGAL CORNER

I NEED A RICH UNCLE !
(the “friends and family” investment round)
By Daniel A. Shmalo, Esq.

After starting in the garage and maxing out their credit cards, many founders of entrepreneurial businesses often try to raise their first outside investment money from friends and family.  To avoid future problems, founders should be aware of certain legal and business issues which are very important to this process.

“Paper” the Deal: When the amounts invested are small, there can be a strong inclination to just take the money and worry about the paperwork at another time.  Wrong! it’s essential to have the investment properly documented in formal legal agreements.  I know what you are saying…”this guy is a lawyer so of course he is going to say that.”  People’s memories of the specifics will diverge over time, and disputes will inevitably arise over what was agreed upon way back when the company was starting out.  In addition, while you can never think of all the “what if’s” you are better off addressing some of the big ones before the fact and then including a fair dispute resolution procedure for any issues that may arise.  Also, investors in subsequent rounds must know exactly what they are buying into, so the company needs to be able to unequivocally show them the number of shares, and related rights, of the first round investors (the rich uncles).

Deal Structure: Friends and family investments usually involve less than $500,000. This is too low for experienced angels or professional investment funds.  In this case it is important to keep the transaction simple, so legal fees and the management time devoted to “doing the deal” are minimized.  Typically, the investment takes one of three forms: (i) simple common stock in return for cash, (2) a promissory note often convertible into stock at a later date, or else repaid as a loan, with interest, or (3) a form “preferred stock.”.

Types of Securities:  If you use a promissory note, it is often convertible at a price per share based on what the investors in a subsequent, usually larger round pay, but with a discount to reflect the added risk assumed by the earlier “friends and family” investors.  In many cases, if the company does not succeed in raising subsequent rounds, it won’t have the money to pay back the loan, so the loan aspect of a convertible investment such as a promissory note is somewhat illusory and obviously risky.  A Preferred Stock is a type of stock separate from the common stock issued to the founders.  Typically, the Preferred Stock has rights or preferences (see special rights below) that are superior to the common stock.

Securities Laws: Structure the friends and family investment so that it won’t cause problems with subsequent rounds.  This requires attention to applicable securities laws.  Even for small investments among friends, state and federal laws apply.  Each state has its own securities or “blue sky” laws covering investments sold to its residents; these can include, for example, requirements for filing certain forms in advance of making the pitch for funds.  Securities law requirements are minimized if the investors are all “accredited” as defined in Regulation D of the federal rules.  An accredited investor is one with a net worth of at least $1,000,000, or income of at least $200,000 in each of the two most recent years or joint income with that person's spouse in excess of $300,000 in each of those years, and who has a reasonable expectation of reaching the same income level in the current year.  However, even accredited investors must be furnished with all “material” information about the company.  “Material” is a technical legal term in this context, but the concept is easy for the entrepreneur to recognize and similar to the “do unto others” saying.  If a piece of information is something you’d want to know about, if you were considering whether to invest in the company, then it’s material and should be disclosed to the investors before they decide to purchase.

Special Rights: Depending on the sophistication of the company and the investors, the “friends and family” group may ask for rights or preferences beyond just straight ownership of company stock (i.e. Preferred Stock).  Several rights, though frequently sought by investors, should be resisted by the company.  Avoid granting protections against dilution, and rights to block subsequent rounds unless the terms are to the liking of the friends and family investors.  This level of control can seriously impede completing later rounds with professional investors.  Conversely, some right to invest alongside subsequent investors is often given, and may be welcome by the company.  The company may be happy to grant some rights and preferences, such as a seat on the board of directors.  Speak to someone who has experience and expertise in this area. 

Conclusion: Even thought they are family, the relationship between an investor and the company is complicated.  Company founders will have to deal with their investors for many years to come.  Investment documentation that is clear, complete and legal will help insure long-term success for the relationship. 

For more information contact:

Daniel A. Shmalo, Esq.