Funding is essential to any early-stage startup. Most entrepreneurs think of funding in terms of professional investors, such as angel investors and venture capitalists, but the most common way to start funding your business is actually by raising money from people in your network – your family and friends. 

There are two important aspects to raising money from friends and family – how you go about approaching people for their investments and also staying compliant with the numerous laws in place to protect investors. This article gives an overview of both concepts.

Part 1: How to Approach Family and Friends About Investing in Your Vision

Here are some tips to receive these types of investments: 

1. Be prepared - First and foremost, you should have a business plan mapped out, including your financial statements, future valuation, and expected returns. It is important to be prepared and display a sense of professionalism - even if the investor is your friend or family member. Treat this like a real meeting. Your potential investor will appreciate the respect you show them.

2. Demonstrate your commitment - Along with having a business plan, it is important to show how committed you are to your own business. By showing figures of your investment in your own business, you will be providing your potential investor with the lasting impression that you are passionate about your business. 

3. Explain the use of funds and the risks - It is more meaningful for investors to see where their money is going, so it is advantageous to explain exactly how contributions will be beneficiary to your business. A chart showing the allocation of money to different projects could suffice. You also want to be sure to explain the risks involved with investing in startups and note that a return is not always guaranteed. 

4. Have a specific amount in mind - Do not ask for “whatever you feel like giving” or hedge on what you would like. Your potential investor will appreciate it if you ask for a specific amount. It shows that you have thought things through and that you are confident in your plans. Also, make sure you do not ask for more than they can give. It is helpful to set a target mark or goal for investments and continually strive to reach that mark. As much as you may want more investments, you certainly do not want to overstep boundaries and ask for more than necessary. Try to always keep in mind the relationship you have with the investor. 

5. Do not overvalue or undervalue your business - It is tempting to offer friends and family large equity shares that a professional investor would never accept. This can make it difficult to take on bigger investments later on. To avoid this, it is important that you bring investors in at fair value. 

Part 2: Staying Compliant With Investment Regulations

Nearly all investments are regulated both on a federal level by the Securities Exchange Commission (SEC) and by individual states. Because of this, entrepreneurs need to be mindful of compliance with all applicable laws and rules when soliciting and accepting funding from anyone – including family and friends. 

What is regulated?

The SEC regulates the sale of the defined term, “securities.” The official definition is extremely long and thorough, but just about all types of investments will meet the definition of a security. In addition, while they may differ in the details, most states follow similar rules regulating these investments. 

SEC regulations vary depending on the number of funds you raise and how you go about doing it. A truly detailed explanation could fill a book, so it is highly advisable to have an attorney guide you through this process. Don’t try to do this alone! When building a business, this is one of those times where you absolutely need qualified assistance as the consequences of noncompliance could be massive – including anything from fines to actual jail time. 

The following will give you an overview of some of the major themes and best practices. 

Make full disclosure to potential investors

First, SEC rules require that the entrepreneurs provide full disclosure regarding business details and the investment to investors. While only required by certain rules, this can be best done through a prospectus. Most importantly, remember that financial information and terms of the investment must be provided in order for the investor to make an informed decision. 

“Blue Sky” Exemptions

The SEC requires that the sale of any securities are registered with the SEC along with all pertinent documentation. This can be a large undertaking; however, there are exemptions you can follow that will avoid any major registrations. These exemptions are known as “blue sky laws,” and you must make sure to follow both the federal and all applicable state exemptions. 

You will almost certainly want to fit within one of the exemptions, and an experienced attorney can help you determine which exemption is the best fit. Additionally, you will likely want to identify your desired exemption first and then make sure your fundraising fits that exemption. 

Most exemptions include variations on a few important concepts:

1. A cap on how much money you raise. Some exemptions allow only up to $1,000,000 to be raised in any 12-month period while some allows up to $5,000,000 and others have no monetary limit. 

2. Restrictions on the methods you use when you go about raising money – specifically, the concept of public solicitation for investment. Many exemptions used by entrepreneurs require that you do not make a “public solicitation” for investment. This means, for example, that you cannot place ads in a newspaper for an investment opportunity, but rather, you can only raise money from people that you have some connection to already.

3. Limits on the types of people you can raise money from – the concept of accredited vs. non-accredited investors. Securities laws look to protect people that truly cannot afford to lose their investments. However, once someone qualifies an “accredited investor,” there are not as many restrictions on taking investments from him/her. There are several ways to be considered accredited, but the most common is to be a person that has an annual income exceeding $200,000 or a net worth of more than $1,000,000. Some exemptions allow you to only have a few non-accredited investors but do not limit how many accredited investors you can have.

While the scope of this article is not to set out the requirements of every possible exemption, to illustrate an example, the following are the requirements of meeting the exemption for Rule 504. 

• The aggregate amount of securities sold in the offering does not exceed more than $5,000,000 in any 12-month period

• Neither the issuer nor any person acting on its behalf offer or sell the securities by any form of general solicitation or general advertising

• The offering is not disqualified as a result of the participation of certain bad actors (new requirement)

• The securities may not be resold without registration under the Securities Act or pursuant to an exemption therefrom

• The issuer exercises reasonable care to assure that the purchasers of the securities are not underwriters

• The offering is not integrated with another offering in a way that would jeopardize the Rule 504 exemption

Crowdfunding

As part of the Jobs ACT enacted in 2012, and as defined by SEC regulations in 2015, companies can also raise money through online crowdfunding, known as “Regulation Crowdfunding.” 

The rules are fairly specific and require that:

• All transactions under Regulation Crowdfunding take place online through an SEC-registered intermediary, either a broker-dealer or a funding portal

• A company may raise a maximum aggregate amount of $1,070,000 through crowdfunding offerings in a 12-month period

• You follow the limit on the amount individual investors who can invest across all crowdfunding offerings in a 12-month period 

• You must disclose certain necessary information in filings with the SEC and to investors and the intermediary facilitating the offering

In addition, securities purchased in a crowdfunding transaction generally cannot be resold for one year. Regulation Crowdfunding offerings are also subject to "bad actor" disqualification provisions, so it is possible that you can lose your qualification.

State-Specific Laws

As noted previously, in addition to federal laws, you will need to stay compliant with all applicable state laws regulating securities. The sale to any investor domiciled in a specific state will trigger the need to comply with that state’s laws. For example, if you have investors in Ohio and California, you will need to make sure to comply with federal laws, Ohio laws, and California laws.

Final Thoughts

Raising money from friends and family has major benefits, and it is usually the first place to start. Make sure to keep in mind all of the legal requirements of taking on investment, and you may soon be on your way to a growing and fulfilling business!

If you are preparing to raise funding or you have any questions from securities regulations to investor agreements, fill out the form below and we will get back to you!