There is a reason why the earliest round of capital infusion into a startup is often called the “Friends, Family, and Fools” round: most founders at this stage usually take money from their own savings and/or inexperienced startup investors, burn through cash haphazardly, mess up their cap table by giving away too much equity (often to too many people), literally break the law by violating securities regulations, and/or fall victim to freelancers and agencies that are happy to work for money but don’t advocate for the best interest of the company.

In this article I’ll briefly discuss rules to follow when raising and spending friends and family money, and I’ll share an example (fictional) story of a founder going through this part of the startup journey to help illustrate how these rules can apply in practice.

RULE #1: BUILD THE ASSET. AVOID TAKING FRIENDS AND FAMILY MONEY FOR AS LONG AS POSSIBLE.

If you’ve been following along in this current series I’m writing on early stage startup operations, there’s an important reason why this is the 32nd article (!); in most cases, founders - especially founders of a web/mobile software company - should do everything they can to formulate, validate, build, and release their idea as a product/service into the world without spending money.

While of course this takes a ton of work (and a fair amount of luck) to get right, not paying for services in the early days should be your goal. Instead, focus on recruiting a co-founding team, building out the features of your product/service together, and marketing your company effectively to gain user/customer traction while leveraging free resources and compensating your team with equity.

Doing this sends a clear signal to angel investors, early stage venture capitalists (VCs), and future team members that you are resourceful and effective at getting things done and that there’s clear market demand for what you are building. This effectively creates value (i.e. the asset you are building becomes worth more) and attracts talent and investors at more founder-friendly terms.

RULE #2: IF YOU MUST TAKE MONEY FROM FRIENDS & FAMILY, CLEARLY WARN THEM OF THE EXTREME RISKS.

At this point it’s important to be extremely honest with yourself and with your family/friends: the most likely outcome here - statistically speaking - is that your startup will not earn a return for investors. In fact, the highest probably is that the return will be zero.

Experienced startup investors understand these odds, which is why they build out a diverse portfolio, expecting most of their bets in startups to fall flat. However, your friends/family might not have this strategy in mind when investing in your startup, so you’ll want to think of the relational dynamics at the next Thanksgiving dinner. Ideally you should have a direct conversation with them in advance where you hear them say something to the effect of: “Yes, I understand that I will most likely be losing all of this money, but I’m willing to take that bet on you and your startup.”

Furthermore, another important issue to address with inexperienced startup investors is the illiquid nature of the investment. Even if there is a return, it may not happen for 7-15+ years (this should be the mental expectation of your investors). In the mean time, selling off the stock isn't nearly as easy as it is when dealing with public stocks, so be sure that people who give you money understand this.

RULE #3: CONSIDER STRUCTURING THE DEAL AS A STANDARD LOAN.

Even with understanding the risks, your aunt and uncle may indeed be willing to shell out $10k-$20k (or more), but a smart move would be to consider paying them back in, say, three years with something like 10% APR interest, irrespective of how well your startup performs.

This allows you to avoid selling shares of your company, which requires that the person is an accredited investor.

RULE #4: DON’T HACK TOGETHER DOCUMENTS YOURSELF. HIRE AN EXPERIENCED STARTUP ATTORNEY.

Before you go any further - if you haven’t already done so earlier in this article series - now is the time to seek out an attorney to work up the documents with your friends/family that are willing to chip in, even if simple loans are the route you are taking.

It’s critical to hire someone who works with lots of startups, as it’s all-too-common for the initial structure and setup for a well-meaning (but inexperienced) attorney to cause problems down the road when not done properly.

Also, while it is possible to find attorneys that work with startups for equity, it’s not recommended since having a neutral party is important for key advisory work (that being said, for more boilerplate tasks like contracts and terms/conditions documents it could be appropriate). What’s more common is a deferral setup so you can pay off your balance once you have raised a sizable round of capital. This can be a dangerously easy way to rack up payables, however, so be mindful of legal fees and communicate often with your attorney about budget expectations in advance of work getting done.

RULE #5: BE VERY SPECIFIC ABOUT WHAT OUTCOMES YOU PLAN TO ACHIEVE WITH THE MONEY.

While at this stage it isn’t absolutely needed to have a robust pitch deck, executive summary, and financial model to share with your friends and family, the more you have in place, the better. If you think about it from an investor’s perspective, they should know exactly what they are getting themselves into and the asset they are betting on having market value down the road to earn a return.

You’ll need to get in the practice of having updated documentation for your investors as you raise later rounds, but for now - focus on a specific plan for what you aim to achieve in terms of your product, marketing, sales, and team growth.

RULE #6: DISCUSS CONVERTIBLE NOTE OPTIONS WITH YOUR ATTORNEY IF YOUR FRIENDS/FAMILY ARE REQUESTING EQUITY IN YOUR STARTUP.

Convertible notes are a simple debt instrument similar to a standard loan (term, interest, etc ..) that also have the option to convert into stock at a later date. When a funding round occurs that places a valuation on the company (which is typically done at the “Series A” level), convertible note holders are granted stock per the terms of the agreement.

I’ll discuss more about convertible notes in a later post in this series, but for now, assuming your friends/family throwing money in meet the qualifications of an accredited investor, it’s generally a good idea to suggest going this route (and your attorney will likely agree).

RULE #7: ONCE THE MONEY IS IN THE BANK, AVOID SPENDING IT ON FULL-PRICE SERVICES; SEEK OUT CASH/EQUITY DEALS TO BUILD OUT YOUR TEAM.

It is extremely common at this stage for founders to over-leverage cash in lieu of not having a co-founder with the skills to develop/market/sell effectively. If your goal is to develop your initial web or mobile application, for example, and you aren’t able to find a full-blown co-founder, find a technology partner that has startup experience and is willing to work for a cash/equity split as an early co-founder with you. This way you don’t need to burn through capital on market-rate services, and you gain a larger team can be on board with you for the long haul.

For planned spend on services like Google Adwords and Facebook marketing, use aggressive techniques to keep your costs to a minimum.

RULE #8: BE EXTREMELY CAREFUL WITH YOUR CAP TABLE.

One of the most common mistakes founders make in the early days is to bring on too many full-blown co-founders (i.e. those intending to work full-time for the company) and give away too much equity. You should discuss all this with your startup-experienced attorney, of course, but in general you want two or three people to have the vast majority of the equity in your company. If you bring on partners to work for cash/equity splits, raise enough cash from friends and family so you don’t need to collectively give away more than ~5-8% to service providers that act as early co-founders to help you launch your product and gain early traction.

Again, do everything you can to avoid paying full price for services from technology/creative/marketing providers in the early days of your company.

PUTTING IT ALL TOGETHER, AN EXAMPLE FOUNDER’S STORY

To help explain how these rules apply in practice, let’s say that Tanya is an ambitious entrepreneur with an idea to build as software application to make meetings more efficient. Her experience in corporate environments of various sizes has given her unique insight into a specific UI/UX she’d like to see brought to market with an initial web app, but she only knows enough HTML/CSS/JavaScript to be mildly dangerous. Her friend Shawn - who is game to be a co-founder - is a brilliant visual designer and digital marketer, but he doesn’t know how to write code at the level that’s needed to bring a digital product to market.

Tanya and Shawn have done a ton of legwork to create beautiful wireframes, mockups, and click-through prototypes. They’ve shown the product to managers at various companies who are eager to give it a try with their teams (and have indicated they have budget to spend on it), but they can’t find a technical co-founder anywhere and it’s been a frustrating experience.

At a family gathering one evening, Tanya’s aunt - knowing it would be an extremely risky bet - said she would be willing to throw in $20k, and is more interested in obtaining stock in the company than going the straight-up loan route (Tanya tried to suggest that, but it didn’t fly).

The next day, Tanya interviewed three attorneys in town that she knows works with startups, and got their opinion on how they would structure the deal with her aunt (and if any of them would be willing to offer her a deferral until she raised more money). Two of them suggested using a SAFE with a $2-$3m "cap", and one of them was willing to roll with a deferral arrangement (so, yes, she found her attorney).

Being skeptical of putting in $20k and obtaining less than 1% of the company at some future date, Tanya’s aunt requested a $1m cap, which was agreeable to all parties involved given the extremely early stage of the company.

With money in the bank, Tanya and Shawn finished interviewing development shops they were looking at in town. Bids came in for around $40-60k to build out the features they wanted for their initial product, and quoted timelines were in the range of 2-3 months. One shop that had team members with startup operating/investing experience was willing to do $20k + 2% over a three month timeline, so Tanya and Shawn decided to roll with them.

Collectively, in the third month they had a product for alpha testing they were able to get in the hands of friends/family to try out, and by the fourth month they had a web app live in beta. They were able to spend a few thousand dollars in Facebook/Google marketing to drive traffic to the site and gain initial traction, and everyone agreed it was time to raise a seed round and get after it.

Thankfully, a friend of friend who writes code found out about the project and was introduced to Tanya/Shawn, expressing interested in jumping on board if it came with equity and a salary (knowing it would only be a startup salary). The three of them, along with their initial technology partner, were able to line up enough meetings with angel investors in town that - backed by the promising traction of the product and the quality of the team - led to the closing of a seed round and they were off and running.

WHEN HANDLED SMARTLY, FRIENDS AND FAMILY MONEY CAN BE FOUNDATIONAL TO YOUR STARTUP’S SUCCESS.

Anyone experienced with startups knows that early stories like our example with Tanya/Shawn are rare. Unfortunately, it’s much more common that a startup team is unable to get a decent product to market (e.g. they wasted money on low-ball service providers), let alone show promising signs of traction. I think it’s safe to say that a vast majority of startups die somewhere between the initial idea and the first few weeks after the product hits the market (due to a lack of customer/user engagement and investor/team willingness to keep going).

However, with the right combination of a quality team, initial service providers (e.g. legal, tech, etc...), and friends and family money spent efficiently, founders have an incredible opportunity to maximize their odds of building a successful company.

Author’s note, this is the 32nd article in a deep-dive series on idea-to-funding startup operations. Subscribe to my newsletter to stay posted when new articles are up. If you haven’t tried Startup Rocket yet, sign up and poke around for free here. My partners and I put together the framework based on decades of experience at both sides of the funding table. Finally, I'd like to thank Andy, Troy, Alex, Jay, and Derek for their extremely helpful comments on early drafts of this article.