Significance Of F-words in Our Startup Ecosystem
Updated: Feb 4, 2020
Whether you are a seasoned professional or the new kid on the block, you probably go to work with a brain-to-mouth filter firmly in place. No unprofessional comments, no uncontrolled flare ups and definitely no F-word as it pops up in your head after yet another frustrating development! But, if you are a startup founder looking to steer your idea to resounding success, you can do away with the last rule.
In the startup scene, F-words are in, as long as you are ready to make significant tweaks in your vocabulary.
Funding is probably the most sought after of all these new F-words, giving founders sleepless nights as they chase after elusive investment offers.
Much of all the industry advice dispensed by blogs and expert columns relate to this contentious issue, and everyone seems to have different opinions on how to bag the right kind of funds. For me, one of the best ways to raise funds is having a friends and family round in the early stage of your venture. This is yet another F-word in the startup ecosystem that can have great significance for any innovative new enterprise. Unfortunately, however, for all the contribution such rounds can have in supporting fledgling new businesses, they are often ignored in the funding narrative peddled by industry publications. The investments that make headlines are usually the ones with recognizable names and far too many zeros in them. These are funds supplied by established venture capitalists looking to up their ante in the startup space.
On the other hand, funds raised from friends and family are frequently relegated to the backseat, because they are usually small in amount, and involve no established players.
Asking for investment from family members and friends can often be an awkward affair, and may require the founders to engage in difficult conversations.
However, it is a great stepping stone to eventually pitching to experienced VCs for getting funded. If you are not ready to have tough talks with your loved ones, you probably won't be all that confident about wooing VCs either. Friends and family rounds are typically carried out in the initial stages of a startup, usually raising a seed fund, or in subsequent funding rounds when the business is still relatively young. Since such rounds are raised from laymen with a limited amount of money to spare, the funds received through this route are usually small. Typically, such a round can generate anything between $10,000 to $150,000.
The money raised can take the form of loan or equity, or even a convertible note.
Once a startup conducts a friends and family round of funding, it can then move to use these funds to build the basics of the business.
Even though the amounts received may be relatively small, they are usually adequate to set up shop, hire a small team to execute operations and most importantly, create a minimum viable product and market it accordingly. This amount allows the founders to put a strong foundation in place, and prepare a springboard for the business to eventually take flight. However, it is important to remember that this is only a preliminary stage of funding, and giving away too much equity can prove to be terribly costly once the business starts to see some success and more investors queue up with their purses in hand.
As I have already mentioned, there are three main ways in which the investment agreement can be made, and each of them has its own pros and cons.
Funds against Equity
Debt Funding from Friends and Family
Loans from loved ones can be one of the easiest & most straightforward ways to get funding for your startup. Even though there may be some initial awkwardness, involving appropriate legal help and drawing up clear and precise paperwork to elucidate the terms of repayment can help one make the process simpler to stick to.
While the legal documentation allays the concerns of the person making the advance, the fact that they are from among your friends and family can help you breathe easy. If the business defaults on the repayment schedule, it is easier to work out a more flexible scheme in this scenario, which can potentially help the business build a robust base without being too hard-pressed for money.
Raising Funds against Equity
In taking in funds from friends and family, founders can also choose to take the traditional investment route, and give away some equity in exchange for the cash. This sounds simple too, but is slightly more complicated than simply taking a loan that can be repaid. In order to determine how much equity you should give to your investor, it is essential to know an accurate valuation of your business. Now, since this round is conducted in the early stage of the venture, it is unlikely that the founders will have a clear idea of how much their valuation should be, or how much it can be projected to grow over time. This complicates the evaluation process, and while taking professional assistance in this regard may be helpful, assessing valuation so early can be quite tricky.
Moreover, giving away equity means taking on a new owner, who will potentially have opinions on how to run the business. Even though the agreement may stipulate on the investor being a silent partner, having tangible stake in the firm still makes them a clear part of the enterprise. For this reason, it is essential to hand over equity to someone the founder can rely upon to take forward the original vision of the business. In addition, it is crucial to leave enough equity to pitch to future investors with. Completing legally binding paperwork is essential to solidify the terms of such a transaction, as it will shape the future trajectory of the firm as well.
Using a Convertible Note
While raising money from friends and family, many founders prefer using a convertible note. A convertible note refers to debt that may be converted into equity later on, at a certain stipulated valuation. This form of funding offers a high degree of flexibility to both investors and founders, and allows them to make modifications to their investment plan based on how the business is performing. This structure combines the pros of both loans and equity-based funding, and allows the investors to take informed decisions about how they want their money to be repaid to them, based on the tangible progress of the enterprise.
Those who make risky investments at the initial stages are allowed to take equity later at a discounted rate, or a previously capped valuation. This allows them to make back their investment and also gain clear returns on the risk they bore by supplying funds without a clear financial track record in the venture's early stage.
Challenges to Navigate in Fundraising from Friends and Family
One of the key problems in raising investments from friends and family is that they are often unaware of the terms and practices usually used in the startup space. In order to empower them to make informed decisions that benefit both them and the business, it is essential to provide them with all the available information on risks, opportunities and financial records. All this information should be explained to them lucidly and concisely, driving home the details they need without boring them with unnecessary number crunching. Explaining the investment opportunity to them in simple terms of benefits and risks is also likely to make them more interested in betting their money in the venture. In this way, not only will you have some money in the bank, but also happier friends and family members who are rooting for your success.
Another challenge that may emerge from raising money from this source is that their inexperience may affect decision making in executing business operations. To combat this problem, it is imperative that the founders establish clear boundaries and assign definite roles to everyone involved in planning and strategising. This will help ensure that too many cooks don't spoil the broth (read: balance sheet) and investors remain happy too. This inexperience on their part can also limit the quality of investor feedback the founders can get, but that is something they can relatively work without in the initial stages.
Fundraising via this route comes with another obvious challenge: in potentially derailing one's social life if the business goes bust. This is why many advise founders to not mix business with pleasure, but being careful and taking smart decisions can help them navigate their business to a successful direction. Even if they fail, equipping friends and family investors with adequate information at every stage of the company's growth can turn them into empowered participants in the process. Once they know that they have made an informed choice to invest, the failure becomes a shared issue rather than something that only the founder (s) should be blamed for.
Why You Should Raise Money From Friends and Family?
Raising funds from friends and family can come with some significant positives, potentially helping your business' success to skyrocket.
Developing A Basic Business Structure
Often, when founders involved don't have the capacity to bootstrap their business, a friends and family round can help them significantly in laying the foundations of a successful enterprise. Using these funds, they can develop the basic products/services and market them effectively to get traction within the startup ecosystem. Once they are able to do that successfully, it can help them garner credibility and reputation within the space, which will fuel further sales and future investments.
Builds a Track Record for Pitching to VCs
Once a startup raises funds from friends and family members, it equips them with a reasonable degree of experience in dealing with investors. When a venture is still at the concept stage or just starting out, few VCs would be willing to shell out cash for the company to set up shop. In such a situation, taking small amounts of money from loved ones can help create a trackable history of taking on investments. A report of how that money was utilized and whether the initial investors earned lucrative returns, can help convince potential VC investors to back a venture.
In addition, having a set of people who have demonstrated enough faith in the business idea to wire money shows the VCs that the proposition has some merit to it. It signifies some interest around the potential offering and signals to the VCs that the founder(s) is/are capable of convincing and satisfying their initial investors. This increases the chance of VCs investing money in the subsequent rounds, as they can see the proof in the pudding (or profits, if you are in the mood for tweaking your vocabulary further)!
A Small Friends and Family Round Helps Promote Prudent Utilisation of Money
Since friends and family rounds are typically quite small in terms of the amounts raised, they can help infuse the venture with a sense of financial discipline. It can propel the business executives to be more prudent about how they spend this limited amount of money and make sure they don't undertake hasty and foolhardy expenses that are unnecessary at such an early stage. Since the founders are accountable to people they close to, they are also more likely to be more cautious about burning through the cash that their friends and family have trusted them with. Since a sense of personal obligation characterizes this funding process, founders are inclined to be more committed to generating great returns for the early investors.
A Bonus F-Word for Every Entrepreneur
As we have seen already seen, taking in money from friends and family often promotes greater financial prudence, culminating in fewer unnecessary expenses. However, no matter what form of funding you get, whether you bootstrap your business or land a lot of VC money, frugality should be the keyword that guides your money matters. Frugal spending and a clear idea of how much the business really needs to spend to have a sustainable foundation, is essential to prevent financial haemorrhage.
Spending too much too soon can often entail biting off more than a young business can chew, and cost investors heavily as the losses mount. Therefore, cautious spending should be an important element of your financial strategy.
Whether you get money from friends and family or not, you should be fine as long as you have this one F-word in your arsenal!
There may be other F-words that can transform startups but in the Indian context, one word I am eagerly waiting for is F for foreign direct investments. FDI inflow is still quite low in India, and a higher infusion of foreign capital can definitely prove to be transformative for our rapidly growing startup space. As the new year progresses, I can only hope that we can up our game with all these F-words and get some new ones in the mix to drive further growth.