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When no one else can see that you and your startup idea are the next big thing, you don’t have to take “no” for an answer. Your next move may be to make the rounds with friends and family.
Friends and family investors are often ignorant of markets or technology, but their help brought to light many companies that later became venture darlings: Turbine Inc., Acme Packet Inc., Lumigent Technologies Inc., and ITA Software Inc., to name a few.
For all its importance to the venture economy, the “friends and family” round is not necessarily an advantageous place to invest. In these arrangements, investors can lose their money — and founders can lose their friends — even if a young company grows up to be wildly successful.
Early investors take the most risk, but the law of the negotiating table is “last money in wins.” Unsophisticated early angels may see their shares crammed down and diluted, and their warrants and protections negotiated away.
Serial entrepreneur Bettina Hein knows what kind of anguish that can cause a founder. Her first time starting a company, she and her co-founders tried to protect their early investors, but a couple of missteps left them in jeopardy of losing their investment.
For an entrepreneur, that kind of outcome can make Thanksgiving dinner with those friends and family members a painful experience. Hein went out of her way to make things right with her early angels — a decision that not only spared her a holiday silent-treatment, but also ended up saving her company from extinction.
“Those people are so important,” said Hein, now CEO at Pixability Inc., a Cambridge-based startup providing digital video-editing services for consumers. “They are your rocks as an entrepreneur, and you’ve got to see that.”
Hein founded her previous company, Svox AG, right out of college. She and her co-founders started out by putting their early angels on a good footing, using convertible debt with a discount so the angels could convert to stock later on at a good price. But before going out to seek venture capital, the Swiss voice technology company decided to do a priced round with later-stage angels, thinking that this would set the table for a favorable pre-money valuation with the VCs. Bad move. Svox missed a milestone, Hein said, that resulted in a down round with their venture investors and crammed down their early angels. The founders decided to absorb the hit themselves.
That turned out to be a good decision, when the venture fund tapped out and Svox still needed more money. They went back to their early angels and brought in additional funding from new angels. Svox still hasn’t exited, but the company is profitable, Hein said, and its technology is widely used by car-phone and mobile-phone makers.
If she had it to do over again, Hein said she would have waited to price her startup until she and her co-founders got to the negotiating table with the VCs. But that’s not the only way to protect your nearest and dearest backers. What else can you do? Mass High Tech spoke with a handful of investors and entrepreneurs who’ve been on the family fundraising circuit before — and lived to talk about it around the holiday dinner table.
FAMILY VALUE #1: PUNT
Taking equity investment is complicated and expensive. At the early stages of launch, a startup can ill afford the legal fees required to generate an equity term sheet. Dealing with inexperienced friends-and-family investors, it may be nearly impossible to set a reasonable valuation.
“Kick the can down the road,” advises startup lawyer Larry Gennari, who left Choate Hall & Stewart LLP last month to found Needham law firm Gennari Aronson LLP. Gennari agreed with Hein: Valuation is better left up to professional investors.
A better solution may be taking the first round of investment as debt, convertible into equity when the company attracts professional investment. This makes it easier to paper the deal: debt terms are less costly to generate and, unlike equity terms, they can be reused with successive rounds of investors.
At early stages, value may be set by gut feeling, Gennari said. It may sound reasonable to take in $500,000 at a $2 million valuation, but when you go to VC investors in six months or a year, you’d better be able to convince them your young company has created at least $2 million in value. Otherwise, get ready for a cramdown.
FAMILY VALUE #2: BUY THEM OUT
If it’s too late and you already took equity investment from Aunt Harriet, buy her out, says Hub Angels’ David Verrill. As a professional angel investor, Verrill won’t co-invest with unaccredited investors. Instead, he prefers to make arrangements to exit the friends-and-family investors from the company.
Debt is one thing, he said, but equity investment from unqualified investors is something he won’t consider, because their involvement is against the law. Securities and Exchange Commission regulations restrict startups from soliciting equity investment from unaccredited backers — that is, those who may not be able to sustain the loss in the event the company goes under.
Of course, such arrangements are common in the very early stages, but once a company advances to Series A and B rounds of financing, they present a risk.
“That investor at some point in the future could bring a lawsuit that said, ‘Hey, you duped me, and now I’m going after not only the company, but the VCs who gave me the haircut and crammed me down,’” Verrill said.
FAMILY VALUE #3: PREFERRED STOCK
Swaptree Inc. CEO Greg Boesel raised money from friends and family to launch his first startup, Sidebar Software, selling software to the legal sector. For his current startup, Swaptree, an online consumer marketplace for exchanging used media, he was able to persuade those investors to back him a second time.
“We were a lot more protective than a lot of people are of their friends and family investors,” he said of his strategy at both companies.
Boesel said an effective way to protect early investors is to offer them preferred stock with a liquidation preference that puts them first in line if the company fails.
Swaptree and Sidebar have both taken capital from VC firms that would have balked at preferred-stock provisions like board control or buyback rights, which could, for example, give an investor an option to exit by selling back shares to the company in five years. But the thin layer of preference Boesel and his co-founders gave to their early backers didn’t set off any such red flags, he said. It also allowed them to price shares in their common stock much lower — a tax advantage for early employees compensated out of the options pool.
With a reasonable early valuation, dilution isn’t a problem, Boesel said. “I can speak firsthand about the dilution that everyone sees in terms of friends and family,” he said. “The difference between making 20 times your money and 17 or 15 or 10 isn’t important.”
FAMILY VALUE #4: EXECUTE
Friends and family get hurt when entrepreneurs aren’t in a strong position to protect them. If a startup isn’t meeting its milestones, that may cause the valuation to slip or may trigger term-sheet agreements allowing later investors to take a bigger share.
Preferred stock, warrants and discounts, along with any other protections, are just so much paper if the founder isn’t in a strong position to negotiate for the next round of funding. On the other hand, if founders took $500,000 and in six months built a company worth millions, that puts the entrepreneurs and their early investors in a good position.
“The idea that agreements will do the protection is only true if things are stable and going well,” said angel investor Joe Caruso, who was CEO at Cyborg Corp. before beginning his investing career.
Caruso said he’s seen entrepreneurs stand their ground when later investors pushed to rewrite early terms. “The better entrepreneurs I’ve seen just stand their ground and say I’m not going to screw my early investors, and if you want to invest in me you’ve got to let stand what I’ve promised them,” he said. “I’ve also seen them fold like a cheap tent and they just abandon their early investors because they get seduced by the big check and the big VC.”
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