Ego and Friends and Family Funding: Phase 3 of the Start-Up Journey

Once the imaginary friend phase is taking shape among the initial team, and the skill of telling the business story continues to improve, the attention usually turns to the realization that the venture is going to take resources and funding. While the founders are typically willing to work for sweat equity, most early hires that may be required in order to produce a minimum viable product (MVP), will most likely require some form of cash compensation. On occasion, with the right imaginary friend description along with a strong and exciting “vision of grandeur,” early employees may be willing to take equity compensation for a significant portion of their efforts.  Regardless, given the many expenses of running a business, funding will inevitably be required.  If the founders themselves don’t have significant bank account balances (and most young founders don’t) the obvious place to go looking for easy initial investment is from closest personal relationships aka “friends and family.” These early funders invest largely on the basis of their relationship with the founders and their passion for the business. While this is usually the easiest money to raise for the business, there can often be a double-edged sword associated with raising too much friends and family investment. Often this early money is raised at a valuation based on the visions of grandeur –– which is typically at a value much higher than a professional investor is likely to invest. And, as such, the value of these investments are typically higher than the risk/reward warranted by a professional. Because friends and family investments are just that, these early investors have no idea and seldom question the price of the investment nor have the ability to rationally evaluate the risk/reward ratio even if they did.

The friends and family round of money is raised on the basis of the visions of grandeur and, of course, the imaginary friend. While it is very exciting to see a cash balance in the company’s bank account for the first time, the founders may also acquire the burden of needing to produce and meet the hopes and trust of these closest acquaintances. While raising funds for the first time is exciting and can be motivating, the involvement of friends and family can also add emotional stress if things don’t work out as planned (and, really… do they ever?). Of course, if successful, the founders can become heroes to those who invested early but in most cases, even if the company is ultimately successful, the dilution that comes with subsequent investment rounds can often substantially limit gains made by early investors.

As early-stage investors, we often see start-ups with capitalization tables (ownership spreadsheets) that imply early investors have overpaid for their value in the business (when compared to the risk/reward value that we are willing to pay). Again, because it is important that these early investors are treated fairly, we will often recommend making appropriate adjustments to their stake so that they are rewarded for their early support of the business. These adjustments almost always come in the form of increased dilution of the founding team.