This will be the very first kind of money that we getting from investors besides what the founders put in. What are the legal rules as far as accredited and unaccredited investors, minimum and maximum investment? Any advice about pitfalls and steps to take so that if everything goes wrong, the relationships will survive?

(I am not a lawyer, nothing here is legal advice, if you are unsure, consult a lawyer, blah blah. But I have built and sold two businesses, and raised money initially from friends & family in both cases.)

I'd echo what Liam has said: draw up a simple agreement to make sure everyone understands what is agreed. I've several times seen casual agreements completely misunderstood by the two parties later on. Writing it down makes you think it through, and makes sure everyone is (literally) on the same page.

The most basic misunderstanding is whether the money is equity (a share of the business, so investors may get many multiples of their money back if the business succeeds, but zero if the business fails) or debt (investors get their money back plus agreed interest if the business succeeds, but zero if the business fails).

For example, I know of two family situations where someone gave a family member money to help them buy a house. Recipient thought the money was a loan. “Lender” thought they were getting a share of the house. Move forward 5 years and the recipient wants to sell the house and pay back the family loan. The lender thinks they own 20% of the house, though, and are expecting to get their share of the house when it is sold. Big difference.

From your (business owner’s) point of view, debt is usually cheaper than equity (you only pay back some fixed interest, not a whole chunk of your entire business); but most investors would sensibly expect their investment to be an equity investment (if they risk losing all their money, they should reasonably expect a big return if things go well).

(It is possible to do both, with a convertible loan, incidentally. This is where your investor puts money in as a loan, and if you later raise more investment that loan money converts into equity at the same valuation as the new money coming in. For example, someone lends you $50k. Some time later you raise $500k at a $2.5m valuation, so that $50k loan turns into 2% of the company (50k / $2.5m = 2%). In practice, you’d agree in advance some discounted valuation to convert the loan into equity. So, given that the early investor has taken more risk, maybe you set their valuation at 50% of what the new money gets. So $50k / $1.25m = 4%, the original lender gets 4%.

The main advantage of a convertible loan is it is quicker and easier to draft than a full-on shareholder's agreement. And you don’t need to agree a valuation for the business until later. This is especially important if local regulations prohibit you from just winging it with a back-of-a-napkin agreement. There’s a good summary here from Mark Suster about how convertible loans work:

But if you can agree a valuation, and your investors (and regulators) are friendly/relaxed enough to tolerate a very simple shareholders’ agreement, you could just write it yourself. I have a standard one-page document which I’ve used for friends & family rounds at my last two businesses, and it just covers four things: drag-along, tag-along, pre-emption and not-unreasonable salary.

Drag-along means that if someone else offers to buy your shares, you can force the other shareholders to sell on the same terms (as the buyer will likely want 100%, you need to be sure you can deliver them 100%, even if your other shareholders no longer like you / are uncontactable / etc.). My standard document just says this:

"If a bona fide arms-length offer is made to purchase all of the Company’s shares, and that offer is accepted by Shareholders holding a majority of the shares, all Shareholders shall be obliged to sell their shares on the offered terms so long as the terms represent no less than fair market value."
(The bit about bona-fide offer and ‘no less than fair market value’ is intended to stop you selling the whole company to your wife for $1 and wiping out the minority shareholders)

Tag-along means that if someone offers to buy the majority of the company, they have to buy all of it (so that your minority shareholders aren’t left holding some tiny percentage of a company now controlled by someone else and they never get to sell). My home-made document covers this in one clause:

"A sale or transfer of a majority of the Company’s shares may only be made if the proposed transferee has offered to acquire all of the Company’s Shares"

Pre-emption means that your early investors have the right to participate in any later funding rounds, on the same terms as the new investors, in order to maintain their same percentage share of the business. My standard document says this:

"No new shares shall be issued unless they have first been offered to the Shareholders in such proportions as to allow them to maintain their pro-rata shareholding after the new share issue."

Not-unreasonable salary means that you (being director and majority shareholder) can’t siphon off all the profits by paying yourself a massive salary, leaving nothing for the shareholders. You agree to only pay yourself maximum of a reasonable market salary.

Those are, in my experience, the key things which will crop up further down the line and should be agreed up front. If you get to the point where you are taking professional investment, you’ll end up with a 50-page shareholders’ agreement covering a gazillion other things. But for friends & family, those are the key issues that I would suggest you decide on and write down.

Answered 6 years ago

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