Raising Capital From Friends And Family: How To Do It Right

Starting a business is a significant financial undertaking. When you’re in the early stages, you’ll need some capital to set things in motion. Often, the first people you might consider approaching for support are your friends and family, sometimes referred to as the “friends and family round”.

Raising capital means securing funding from others to help your business grow. In New Zealand, you can raise capital from friends and family through two main methods – debt or equity. While this may seem straightforward, there is a proper way to go about it.

Many startups mistakenly assume that friends and family represent an easy source of funds. However, even in these cases, it’s crucial to maintain the same level of professionalism you would with any other investor.

In this article, we’ll guide you on how to raise capital from friends and family correctly.

Debt Or Equity – Which One Is Right For Me?

Your first step is to decide how you want to raise that capital.

There are various ways to secure early funding for your business (for a broader understanding of financing your business, check out our Finance Guide here). When reaching out to friends or family, generally your options are either debt capital or equity capital.

Debt

Opting for debt capital from friends and family typically means you’re taking out a private loan.

Private loans come in two forms – secured and unsecured. A secured loan involves personal or valuable assets (like your house) that the lender uses as “security”. An unsecured loan does not require such collateral.

Even if a friend or relative lends you money in good faith, they may still have questions. What is the loan amount? What’s the interest rate? When will it be repaid? What happens if the loan isn’t repaid?

To avoid any future misunderstandings or strained relationships, it’s best to establish clear terms and ensure your legal agreements are in order.

The contract you’ll need is known as a Loan Agreement.

For a secured loan, you may need to register the ‘security’ on the Personal Property Securities Register (PPSR) in New Zealand. You might also require a separate Security Agreement.

Learn more about loans here.

A loan is a suitable option if you can manage repayments and have friends and family willing to lend you money. It’s particularly advantageous if you prefer not to dilute your equity too early.

However, for many startups and small businesses, making repayments isn’t feasible, and risking personal assets as security is not an option.

In such cases, equity might be a more appealing alternative.

Equity

Equity fundraising involves investors receiving company shares in exchange for their investment (even if your company isn’t profitable yet!). There are also variations of equity, such as the “SAFE Note” introduced by Y Combinator in 2013, or the more traditional “convertible notes”, which we discuss here.

Equity can seem like a win for startup founders: receiving funds now without immediate repayment obligations. However, it comes with the risk of parting with ownership of your business. A 10% stake might seem insignificant today, but it could be worth a substantial sum in the future, which you would otherwise retain.

For investors, equity fundraising is attractive due to the high-risk, high-reward potential.

Equity fundraising carries its own set of risks and benefits for both founders and investors. If you decide to raise equity capital from friends and family, it’s crucial to do it correctly.

What does raising equity involve?

Step One: The Pitch

Approaching friends and family for equity capital starts with a “pitch”, just as you would with any other investor.

A “pitch” is your opportunity to present your business idea, the problem it solves, and its future potential. This is how you persuade them to invest in your startup’s growth.

Before your pitch, you’ll need three things.

First, a “pitch deck” – a presentation with simple, engaging slides summarising your pitch to appeal to your audience.

Second, prepare a document pack with financial or industry data supporting your business idea’s viability. These documents lend credibility to your pitch and reassure potential investors of your startup’s value.

Lastly, a Term Sheet is essential. It outlines the investment’s key terms, addressing questions like: What ownership stake will I receive? What will our long-term relationship look like? How will my investment be managed? The Term Sheet provides these answers.

Having these documents ready demonstrates thorough preparation and instils confidence in your investors about entering a genuine business relationship.

Additionally, consider a Non-Disclosure Agreement (NDA) before discussions to protect any confidential information shared during meetings (but use NDAs judiciously).

Step Two: Formalising the Agreement

After pitching to your friends and family, and they’re interested in investing, what’s next?

Now, it’s time to consider the legal aspects.

To meet your legal obligations to your investors, you’ll need several legal documents:

• A Shareholders Agreement
• A Share Subscription Agreement
• IP Assignment Deed

These may sound daunting, but we’re here to explain.

Once someone becomes a part-owner of your company, they are officially a “shareholder”.

This is an exciting step, but it’s vital to ensure mutual understanding of how this new relationship will function:

• How are decisions made?
• What happens when a shareholder wants to exit?
• How are disputes resolved?

Clear guidelines are beneficial for both personal relationships and business, particularly as your company grows and the stakes increase.

That’s where a Shareholders Agreement comes in.

A Shareholders Agreement is a crucial contract among business owners that addresses issues from share ownership to issuing new shares, dividend payments, and dispute resolution.

If an existing Shareholders Agreement is in place, review it to ensure it accommodates the new shareholders’ needs.

You’ll also need a Share Subscription Agreement, which details the terms under which a new shareholder is issued shares. It specifies the number of shares, any vesting conditions, the timing of the share issue, and the share price.

For straightforward cases, a Share Subscription Letter may suffice. However, more sophisticated investors may require a comprehensive Share Subscription Agreement with additional protections.

Last, an IP Assignment Deed is necessary to ensure the company owns all intellectual property, which can be included in the Shareholders Agreement or as a separate document. This safeguards the company’s value by preventing individual shareholders from owning key IP assets.

Key Takeaways

We’ve outlined two ways friends and family can support your business – through debt or equity. However, it’s crucial to formalise these arrangements with the proper legal documents.

Why is this necessary?

Even with friends and family, you’re entering a business relationship, so clarity and agreement on terms are essential. The right contracts prevent disputes and awkward situations, providing both parties with confidence in the business relationship.

As your business grows, you’ll want to avoid conflicts with shareholders due to a lack of formal agreements.

Raising capital from friends and family correctly ensures a professional relationship, satisfaction on both sides, and stress-free family gatherings.

If you’re unsure about the legal documents or need assistance formalising your capital investments, we’re here to help. Our friendly team can arrange a consultation with one of our corporate lawyers to advise you on your next steps, or we can immediately start preparing your legal documents.

Contact our friendly team at 0800 002 184 or send us an email at [email protected] for a free, no-obligation chat.

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