The Fatal Flaw of Family & Friends Funding Rounds

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A family and friends investment round can cripple a startup’s future fundraise chances, if the terms are not properly vetted in the context of the next round of capital.

Worse yet, this common misstep is often done with complete ignorance that the founder is doing anything wrong.

I recently had a conversation with a co-investor that went like this…

Investor: “We’re currently looking at ABC Company, have you seen that one?”

I replied that I was familiar with ABC Company.

Investor: “The company’s technology is interesting, but they raised a family and friends round early on that set the valuation too high, too early.

The valuation that they are soliciting right now is way too high commensurate to the traction that they have…All of the previous investors are going to have to take a severe haircut on valuation for us to invest…

I don’t know if the founders and previous investors are going to want to do that.”

Unfortunately, this is all too common to me as an investor. But then again, I also committed the exact same error as a founder.

In 2016, my father, also my co-founder of my FinTech startup, agreed on an investment with my grandfather.

The terms were $100,000 at a certain equity percentage in the company.

One year later, our startup was accepted into the FIS Startup Accelerator program. FIS requested a Zoom call with our team to discuss the SAFE agreement and the terms that FIS was to invest in us on. The valuation cap of that SAFE was essentially 1/2 of the valuation of what my father and grandfather had agreed to just one year earlier.

In that moment, on that Zoom call, I remember asking myself, “Have I been thinking about this fundraising thing all wrong, this entire time?”

It was a rhetorical question. I knew the answer.

✅ The Fatal Flaw of Family and Friends Funding is that the founder(s) and the family members (investors) decide the terms in isolation, completely unaware and disconnected from what later stage VCs think an appropriate market price should be. ✅

It’s Rarely About This Round, but Rather the Next Round

Any funding round, whether or not it’s a Family and Friends round or a Series E round, should never be thought about in isolation. The terms discussion should always be appropriate relative to what they believe the next round will be at.

✅ The key question is, “What terms will set this startup up to be investible in the next round?” ✅ 

Don’t Hate the Player. Instead, Know the Game

Unfortunately, at the family and friends round, many founders don’t realize what game they are playing.

Let’s extend the scenario of the startup above. The investor didn’t share the details with me, but I’ve spoken to too many startups that I can imagine it happened like this...

The founders decided to raise $750,000 from family and friends. After some conversation, they decided a sensible valuation was a $8 million post-money valuation cap on a SAFE. $750,000 is essentially 9.3% of the company when it converts, all other things being equal.

With the funding, the startup was able to acquire some customers and generate $12,000 in monthly recurring revenue. Now, the financial runway is shortening and the startup is trying to raise $1 million.

The founders look at the existing family and friends investors. But now, the family and friends are tapped out and don’t have an interest to invest any more in the $1 million round. So, the founders look to the next round of investors - angel investor groups and VC firms.

In conversations with angel groups and VCs, the founders get a rude awakening - no one is interested in investing above $8 million post-money valuation. In fact, the potential investors are interested in a $1 million investment at a $5 million post-money valuation.

The founders are incredulous. They raised at an $8 million before without any customers or revenue. Now, they have a number of customers at $12,000 a month and these investors want to invest at much lower valuation?!

It sounds heartless, but I’m just going to say it - it’s not the investors’ problem. The investors have no skin in the game. Instead, they have tremendous optionality. They can walk away and move onto another deal where the valuation is appropriate.

Unfortunately, the founders did this to themselves. The worst part is, they did it completely accidentally.

The Fatal Flaw of Family & Friends Funding leaves a startup in a dreadful dilemma:

1. Take the investment, giving the company the ability to grow faster, but take a serious valuation haircut. Or,

2. Don’t take the investment, keep the valuation and cap table, and sacrifice fast growth potential.

I’ve seen founders opt for different paths, depending on which type of company they want to build.

The best approach is to avoid this situation entirely - do it right from the beginning.

Founders need to know the game that they are playing.