In Investment, Startup Management

Most small companies start with money from the founders, their families and their friends.  Occasionally founders may find someone outside that circle to give them money – usually known as “fools” as they often don’t really understand the opportunities or risks involved in early stage investment.  Founders, Family, Friends and Fools – the “Four Fs” of seed funding.

Unfortunately, many of these relationships end with ex-founders, as the business fails.  That can result in ex-friends when the business loses their money, and possibly ex-fools as they learn about early stage investment the hard way.  You’re stuck with your family, but losing their money on a business venture can still make relationships pretty difficult!

Organised investment through angel groups and investors is a formal process, and there are inevitably long contracts to sign, draw up by lawyers at great expense.  Many businesses starting out and taking funding from friends and family will keep things simple, and will receive money with no formal agreement in place.  While spending money on lawyers in the early days can seem like a waste, that shouldn’t mean that you take money without an agreement of some sort in place.  Here are some of the common areas of dispute…

Loan or Investment

It is important that FFFFs understands whether they are making gift, a loan, or an investment.  In each case, it is also important that they understand what they stand to get back and when:

  • Gift or Donation
  • Loan
    • Is the loan to the entrepreneur as an individual, or to a company
    • When will the loan be repaid, an over what period
    • What, if any, interest will be paid on the loan
    • Will they have to pay tax on interest?
  • Investment
    • Will they receive dividends on their shares
    • Will there be an opportunity to sell their shares (to you, or others)
    • In each case, when will this occur and what might they stand to get
    • As an investor, will they have any influence over the running of the company
    • Will they have to pay tax on dividends or gains?

Bear in mind that new investors are reluctant to see their money used to repay loans or early shareholders – it may not be practical to repay FFFFs early just because the founders want to.

Risk

Entrepreneurs raising money for a business idea always focus on how great the outcome is going to be for everyone.  Experienced lenders and investors understand that there is also the possibility of losing all their money, and it is important that FFFF’s understand this too.   So added to whether it is a loan or investment, FFFFs should understand what happens if the business doesn’t go as well as expected, or if it fails altogether.

Guarantees

By default a loan to a limited liability company “disappears” if the company fails.  However, most small company loans from banks will seek a “personal guarantee” from the founder(s).  If a guarantee is in place, then the founder(s) still owe the bank repayment of the loan if the company fails.  Potentially, this could result in loss of the founder(s) savings, home, or even bankruptcy for the founder(s).

FFFFs may assume that founders are personally guaranteeing any loan (or even investment) that they make.  Entrepreneurs may need to accept this obligation in order to raise money, but it is better to be clear at the start that there is no personal guarantee if that is the intention.

Memorandum and Articles

 Limited Liability Companies come with an “owners manual” called the “Articles of Association”.  These set out what rights and obligations shareholders and directors have, and how the company will be run.  Entrepreneurs accepting investment should ensure they understand the rights of their new shareholders.  It is possible to amend the articles through an appropriate process (set out in the articles!) but this is much easier to do before investors come on board.

Plan for the Worst

 Whether it’s with lenders, investors or fellow founders, it’s much easier to plan for the worst at the start of the project.  Consider what will happen if a fellow founder dies or falls ill, or if the founders simply can’t work together any more.  What happens if a lender falls ill or divorces and needs their money back?

Use Professional Advisors

 When it comes to loans, investments, articles of association, shareholders agreements and contracts the best solution is to get expert advice from lawyers and accountants specialising in this sort of work.  The lawyer who helped you buy your last house or the accountant that does your personal tax may not be suitable –  this is a specialist area.  When given a clear instruction of what is needed, or presented with a draft to check for potential problems, professional advisers do not have to be expensive.

Apply Common Sense

Finalising an angel investment of £100,000 or more will use legal and accountancy services worth many thousands or even tens of thousands of pounds.  Common sense dictates that borrowing £2,000 from a friend should not attract the same legal costs.  If it’s £200 that is in question, using lawyers is not going to be economically sensible at all.

I am not a lawyer or accountant, but I am pretty sure that even if there isn’t a lawyer or accountant involved in the deal, it is better to have something in writing and signed by both parties covering the issues described above (and any others that seem relevant) than to have no agreement at all.

Deferred Problems

Any significant transaction is likely to see the company accounts being closely scrutinised, and the other party examine related legal documentation, for example:

  • Selling the company
  • Taking out a bank loan
  • Raising investment from professional investors (angels or venture capitalists)
  • Winning a big supply contract
  • Forming a partnership

These transactions will likely require that any informal arrangements are formalised  but entrepreneurs may be in a weak negotiating position with FFFFs if there is nothing in writing to guide the outcome!

Funding from FFFFs  is vital to the small business community, and such funding is often the most important commercial deal a company will make.  The founders may be dealing with people they know, but it should still be treated as a commercial transaction, with a contract and a mutual understanding of what will happen, even if things go wrong.

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