Raising Money from Friends and Family

Posted on May 29, 2012

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When you first start a business, the lack of operating history makes raising debt and equity capital difficult. New businesses are inherently risky and not many people have made money investing in start-ups. Friends and family, however, want to support entrepreneurs that they know. They will come in with money to support them, and the rationale behind their investment may not be entirely economical.

These investors are termed friends and family because this investor group is making the investment for reasons other than pure economic gain. A parent may want to help a child. Business school friends may want to help other business school friends. They generally believe in the concept, support the project and want the company to succeed. However, they are investing outside of their normal investment profile, and they are doing so typically because they like the person raising funds. For this reason, the round is often called the ‘friend, family and fools” round.

Lawyers and the law can handle commercial transactions based on an arms-length negotiation. However, when people enter into commercial transactions for ulterior motives, the legal mechanics begin to have issues. Nonetheless, documenting these transactions is essential. As one practitioner told me, “Be sure you have your documents right, and if you are dealing with friends and family, make double sure.”

Estate and gift tax laws create one hurdle for these investments, particularly for the family side. If a parent “gives” a child an investment in a company or an actual company or another tangible benefit, then the gift tax laws are implicated. This does not preclude such an investment, but such investments need to be structured in a way so that the IRS does not deem the investment a gift, or alternatively, gift tax may be owed. A loan, for example, needs to be a bona fide transaction; among other terms, interest must be at least what is at the applicable federal rate (AFR) for the term of the loan. 1

Even if you put aside the gift tax consequences, investments that are gifts are problematic. Simply giving money to a corporation does not equate to a contract. The interpretation of that situation (without further documentation) usually implies that the money was an advance, and unless a term of repayment was specified, such an advance would probably be treated as a demand loan. A demand loan for a start-up may not be the intent of the parties and may put the capitalization more at risk than necessary.

However, I will also say that on the other end of the spectrum, I have seen friends and family investors be too restrictive and too punitive. Because the investors are taking a high risk, they may have terms that are too demanding. If you are getting stock and a personal guaranty of the return of capital, you may be getting the appropriate investment on risk adjusted basis, but if you are asking for a guaranty are you really doing the person any favors?

From a more fundamental perspective, both the company and the investor must be in the right frame of mind. They need to take one another seriously and respectfully. Neither party needs to take advantage of the other. The terms need to be fair, but everyone realizes that the market is being adjusted (slightly) because of the relationship. They must be willing to work with each other and must be willing to have a complete risk of loss if the business goes south. That is a very personal matter, and while it works and is sometimes necessary, it often does not work and strains relationships.

Mike Goodrich
Goodrich Law Firm, LLC

1 You can find the current afr rates at the IRS website –www.irs.gov (search for AFR rates on the site)

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