Another option for your friend or family investment is a combination of equity and debt. To do this, you would issue your friend or family member common stock at par value (typically $0.0001 or lower at the company’s early stages) as well as a promissory note for the remainder of the funds (i.e. the business accepts a loan).
This approach is beneficial to the friend or family member for two reasons. First, receiving an ownership share of the company means that she will share in the upside of the company. Second, because the promissory note is a debt instrument, she has a right to have her investment paid back with interest.
This approach is also beneficial for the company. Because the common stock is purchased on the same terms as the company’s founders (i.e. at par value), this avoids the valuation issue with the common-stock-only approach above.
From the company’s standpoint, the issue with this approach is that the company is taking on debt, which is not necessarily the best way to get started with a new business if it can be avoided.
Another option is to take the money as a gift from your friend or family member. However, gifts are not generally an enforceable contract because of the one-sided benefit of the transaction. Thus, the gift can potentially be revoked by the friend or family member. Additionally, you are going to need to find quite the generous friend to simply give you money in exchange for nothing (other than gratification of being a good friend).
If at all possible, the best way to approach friends and family transactions is to limit the deal to friends and family who qualify as accredited investors and to use convertible security instruments. Barring wealthy friends and family that meet the definition above, the common-stock-plus-promissory-note approach is likely your best option to avoid premature valuation.
Unfortunately, there simply are not many tools available to entrepreneurs seeking to raise funds from friends and family without hitting major risks. Thus, it is smart for founders to bootstrap as much as possible prior to having to raise funds.
Stay tuned for Part Three of this blog series. This article was contributed by our friends at SPZ Legal. To discuss various options for structuring an investment from friends and family, please contact them for more information.