Friends and family investors take the most risk, so why are they often overlooked further down the line?
Wednesday, August 23, 2023
Author: Iain Baillie
The average individual investment in a friends and family funding round is roughly £18,000. That’s hardly small change, especially when you’re one of the earliest investors in a startup. And while there is usually an EIS benefit, tax-reduction should not be the primary driver of an investment.
Often pre-revenue and without the data points needed for a concrete valuation, investors are taking a huge risk. Despite this, that risk is rarely rewarded. In fact, it’s often the opposite, with these earliest of seed investors taken for granted due to their proximity to the entrepreneur.
Friend and family funding rounds are a tricky thing at the best of times. When Jan Koum and Brian Acton secured $250,000 from five of their friends to kick-start WhatsApp, they weren’t tapping up a wealthy aunt, these were ex-Yahoo, seasoned tech-heads who had been on the front line of the dot-com bubble. Most friends and family rounds look nothing like that. They’re scrappy, exhausting and emotional, and can put immense strain on relationships.
When it comes to equity distribution, the process can be opaque and vague. Entrepreneurs understandably tend to give away as little equity as possible with early investors rarely challenging valuations, often accepting what they're offered without pushback. As harsh as it sounds, for many friend and family investors, the venture never reaches a point where this results in a problem. An overwhelming majority of startups fail, around 80%. If they’re aware of the risk – and any entrepreneur should be making sure their friends and family are crystal clear about what’s at risk i.e. their entire investment – then while they may not offer to invest in the next venture, they should not feel short changed.
It’s when a venture begins gaining traction that complexities arise. As companies move beyond seed stage and start attracting growth capital, which comes with more experienced investors attached, friends and family risk being overshadowed and rewarded with inferior share classes, - pushing them down the capital structure.
This reduces their already diminished influence over an exit. We believe that once a firm reaches profitability, it should be in a position to orchestrate a liquidity event, especially considering today’s depressed business environment and the fact that companies are staying private longer. Growth investors build this longer horizon into their business models, and are happy to wait for the big payout come IPO or acquisition, friend and family investors may want to cash in sooner. Via platforms like Asset Match, firms can facilitate this, rewarding the risk that their early backers have taken with a share auction. This isn’t just the right thing to do, it’s a good business move, allowing founders to tidy up their share register and perhaps take back equity. By facilitating these events through a third party platform, it can also address some of the unique awkwardness that might otherwise exist when trying to influence personal contacts to instigate a liquidity event.
The narrative surrounding friends and family as investors can be a little folksy, but it’s important to recognize and value their contributions and the risk that they’ve taken. While more sizable investment may take a company to the next level, that would never have been possible without that initial seed investment. The contributors of that vital capital deserve at least the same consideration as any other investor.