# Fair Compensation for Friends and Family Investing in Startups
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Chapter 1: The Challenge of Early Investments
When starting a business, the initial investors often take on significant risks. Are you adequately rewarding them for their faith in your venture?
Recently, I had a discussion with two startup founders who were grappling with how to structure a deal after receiving funding from a family member. They were at odds over a fair valuation, which jeopardized the investment process. One founder wanted to allocate a larger equity share to the investor due to the risks involved, while the other was focused on conserving equity for the company’s future success.
Determining who was in the right isn’t straightforward. However, it is clear that early-stage "friends and family" investments are a common phenomenon in the startup landscape. Often, inexperienced founders persuade relatives or friends to provide seed capital without a thorough understanding of the startup process. This situation can be likened to the "blind leading the blind," where neither party has enough experience to establish a fair deal. Consequently, the resulting agreements can vary widely in terms of equity stakes, often leading to detrimental outcomes for startups.
I've witnessed scenarios where founders granted excessive equity for minimal investments, crippling their companies' future financing opportunities. Conversely, I've also seen instances where overly optimistic founders offered minimal equity stakes, leaving early investors with insufficient returns even if the company later achieved a substantial exit.
So, how can you find the right balance? If you're securing initial funding from friends and family, what approach ensures fair compensation for their investment and acknowledges the risks they're undertaking?
Description: This video offers insight into explaining the Friends and Family Round, crucial for understanding early-stage investments.
The Enormous Risk of Being a First Investor
My own experience reflects the challenges I’ve mentioned. My first investor was not a well-known venture capital firm or an experienced angel investor, but rather a mutual friend who had never previously invested in a startup. He believed in my co-founder and me enough to contribute $50,000, despite the significant risks involved.
At that point, all we had was a concept for a business—essentially just an idea without any proof of viability or experience in building startups. Looking back, the odds of our venture succeeding were so slim that it would have been wiser to place that money on a roulette table in Vegas.
Balancing Risk and Necessity
Despite the daunting odds, I distinctly remember the discussions about compensating our initial investor. This debate mirrored the one I witnessed between the two founders seeking my guidance.
To his credit, our friend didn’t impose pressure on us; he encouraged us to determine fair terms among ourselves. Initially, this seemed like a flexible arrangement, but it complicated our discussions. We had to strike a balance between what we believed was fair for him and what was best for our company—a challenging task given the uncertainty of our future.
This dilemma is one that every entrepreneur faces when assessing their company's value. The difficulty arises from the necessity to predict an unpredictable future. My co-founder and I envisioned a scenario where our company would sell for billions, leading us to overvalue each percentage of ownership.
How can anyone make sound decisions when they are caught up in lofty aspirations?
Leveraging Convertible Notes
Fortunately, the startup ecosystem offers a practical solution to the valuation dilemma: the convertible note. I wish I had been aware of this option in my early days as a founder.
In essence, a convertible note recognizes the inherent challenge of valuing early-stage startups, allowing founders to defer this conversation. Instead of agreeing on valuations prematurely, convertible notes let companies grow until they reach a more stable valuation through a "priced round." At that point, the notes convert into equity at the pre-established valuation, minus any agreed-upon discount.
For instance, if a startup's first round is priced at $2 million and early investors hold convertible notes with a 25% discount, their investment effectively converts at a $1.5 million valuation.
Understanding this concept makes convertible notes a straightforward solution and arguably the best route for securing early investments.
Convertible Notes: A Fair Yet Imperfect Solution
While convertible notes provide a pragmatic approach for early investors, they still may not fully address the fairness issue. Although they offer discounts to investors, these do not adequately compensate for the substantial risks involved. My first startup didn’t reach the billion-dollar exit we envisioned; in fact, it ultimately failed. All the time spent deliberating over terms proved fruitless.
In reality, this scenario is likely familiar to many entrepreneurs. During the initial phases of your startup, the likelihood of success is so low that focusing on perfecting investment terms can divert attention from more critical tasks.
When it comes to setting terms for your earliest investors, prioritize efficiency over minute details. Download a standard convertible note template, establish a reasonable discount (20% to 25% based on your level of generosity), and get back to building your business.
If your startup fails, at least you won’t have wasted precious time on discussions that ultimately didn’t matter. Conversely, if your venture flourishes into a billion-dollar success, your investors will be too busy celebrating to voice complaints.
Description: This video provides a step-by-step guide on closing your first startup funding through friends and family, essential for new entrepreneurs.
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