Friends & Family Vs. Angels — Preseed Financing
There are two sources of early-stage preseed financing: friends and family and/or angels. Although many angels invest in business of friends and family, a typical friends and family round is significantly different in terms of deal terms and expectations then an angel round. Below we try split the difference and try to help you asses if you should ask for money from friends/family or go to angels.
Friends and Family Round
As the name suggests, a friends and family round is an investment round wherein the funds are provided by friends and family of the founders. The source of funds come from people you already know and most importantly trust you. Friends and family may not fully understand the business you are building. This is generally the first round of investment for a company and takes place at the earliest stage of company growth. The company may not have fully developed operations, or even a dedicated revenue model, at this point. Many SV insiders call this the friends and fools round.
A friends and family round size typically ranges in anywhere from $10,000 to $150,000 in funding. The ticket size is between $5,000 to $10,000. The valuation usually is below $1 million. The aim of such round is to allow a startup to get through its first few months of operation by securing office space, and/or purchasing other key resources needed to become operational.
An investment in a friends and family round usually takes place in three ways: (a) loan (convertible note or SAFE); or (b) equity (common stock).
Loan: This again would be a relatively straightforward way to raise money in a friends and family round. Either the money-granting party will seek interest on the loan, or dollar-for-dollar repayment. However, the downside of raising funds through such loans is that you end up tying some of your business’ cash flow in the repayments, which might be crucial in early stage of the startup.
Equity: Under this approach, the friend or family investor would receive shares of common stock in the startup either through straight equity subscription or through instruments such as convertible notes. It is typically advised to execute convertible notes instead of straight equity subscription. In this way, the investors do not directly become shareholders of the company but would have the right to have their investment converted to stock in the company at a later date usually on the occurrence of a future equity financing round. In case of friends and family investors these convertible notes would convert into common stock and not preferred.
Unlike sophisticated investors, the family and friends investors participating in this round receive common stock instead of preferred stock in the company if they choose to invest in exchange of equity. Thus, these investors do not get a dividend preference, liquidation preference, and conversion rights as enjoyed by other investors holding preferred stock. Additionally, investors from friends and family round do not get the investors rights such as pro-rata rights, information rights and board seat or observer rights, that are given to angel and other venture capital investors.
After or in parallel to the family and friends rounds, you can reach out to angels. Angel investors are wealthy individuals or group of individuals who invest personal funds in start-up or early-stage small businesses. Angel investors are far more sophisticated or knowledgeable (theoretically) in startup financing than typical friends and family investors. Round size for angel rounds is between $100,000 to $1 million. Investment tickets are between $10,000 to $100,000. Pre-money valuation for angel rounds is usually between $1 million to $5 million. In order to secure angel funds startups need to generate income (low figure MRR), sign pilot agreements with customers and have an MVP.
An angel investor would either invest through a convertible note, a simple agreement for future equity (SAFE), or preferred stock subscription (very rarely). Convertible notes and SAFEs are more popular approaches in case of an angel round.
(a) Convertible Note: A convertible note allows the investor to get a return on the investment on the maturity date or a right to convert the debt instrument into an equity ownership interest on the occurrence of a future financing round. This allows the investor to avoid negotiating all of the terms of the equity financing at the early stage of the startup growth and defers these negotiations until a future round of equity investment.
b) SAFE: A SAFE allows the investor an option to purchase preferred stock in the startup at a future date. It allows the investor to convert the investment into equity whenever a future funding round is raised. However, unlike convertible notes, there’s no repayment or interest aspect in a SAFE and it only kicks in on the occurrence of a defined trigger event which is usually a future financing round.
c) Equity Subscription: Another way for an angel to invest would be through directly subscribing to the preferred stock in the startup. However, at the stage of raising an angel round it is usually too early for reliable company valuations, and therefore angel funding rounds are often structured as convertible notes or SAFEs instead of an equity grant.
As explained above, angel investors will usually end up receiving a form of preferred stock in the company in return for their investment. Preferred stock will generally provide the investor with a liquidation preference, and conversion rights. A liquidation preference allows the investor to receive a return of their money or a multiple thereof before other owners receive any funds from the sale of the company. Conversion rights allow the investor to convert their preferred shares into common share ownership if owning common shares is advantageous for any reason.
Additionally, depending upon the leverage the angel investors have on the startup they could get certain investor rights such as pro-rata rights, information rights and board seat or observer rights. Pro-rata rights allow an investor to maintain their portion of ownership in a company when the company takes on new investors. Information rights grant investors the right to receive, at some pre-determined interval, information about the company’s status and finances. Some angel investors might negotiate to get a board seat making the investor a member of the board of directors of the company with legal, corporate governance rights to vote on initiatives that require board approval. However, it should be pointed out very few angels are able to get board seats in startups; the exception being super angels (Joanne Wilson, Jason Calacanis or Ron Conway) that are highly sought out by founders. On the other hand, angel investors could negotiate for board observer rights which allow the investor or its representative to attend and observe board meetings without actually giving them a legal vote on any board matters.