Preparing for Funding Ep3: Friends and Family Funding – Recut

Office Hours is our podcast covering general issues related to small businesses and startups. Preparing For Funding is a series of Office Hours episodes hosted by VW Partners Kevin Vela and Rad Wood about getting your company’s legal house in order before taking on funding. We are recutting this series to reflect updates in law and venture trends in the last 5 years to better help you navigate through preparing for funding.

In this episode, we discuss how to structure a Friends & Family Round to avoid risks that affect later-stage financing rounds.

Time Stamps

  • 1:00 – Why People Invest
  • 3:25 – Risks of Early-Stage Investors
  • 4:50 – Security Considerations in Early-Stage Rounds
  • 7:26 – Lego Brick Theory
  • 8:46 – Early-Stage Round Financing Options 
  • 11:13 – Runaway Valuations
  • 16:17 – Keep Your Investors Updated

Related Content

Click here to view terms used in this podcast
Angel Financing

Angel Financing refers to a startup’s financing round whereby the investors are angel investors (see Angel Investor). This round typically comes after a Friends and Family round, but before a Series A round. Many Seed and AA rounds are composed of angel investors.

Learn More

Anti-Dilution refers to a right, usually requested by investors purchasing preferred shares, to protection against future rounds whereby securities are sold at a lower price than the current round. There are several types of anti-dilution. See also Broad-Based Weighted Average, Narrow-Based Weighted Average, and Full Rachet.

Learn More
Angel Investor

Angel Investors are individuals who provide seed or startup finance to entrepreneurs. In addition to an investment, angel investors may also provide industry contacts and knowledge.

Learn More
Annual Recurring Revenue (ARR)

Annual Recurring Revenue (ARR) is the amount of revenue a company generates from recurring payments over a year.

Learn More
Beta Testing

Beta Testing refers to testing performed by the intended customer, with the goal of getting user feedback on the product.

Learn More
Blue Sky Laws

Blue Sky Laws are securities restrictions enacted at the state level, established to protect a state’s investors. These regulations prohibit brokers and investment advisors from recommending, soliciting, or discussing any security with a client unless that security is compliant with the Blue Sky laws of the state that the investor resides in. With startups, the more states they plan to raise money in, the more sets of Blue Sky laws they will have to comply with.

Learn More
Burn Rate

Burn Rate is calculated as monthly revenues less expenses. It is typically negative because expenses are so high for a startup relative to revenues. Burn rates are helpful in measuring how quickly a startup will go through all of its cash.

Learn More
Business Plan

A Business Plan is a long document developed by a startup which lays out the blueprint for the startup – including the revenue model, growth plans, market information, and other relevant data. Business plans are not typically requested by investors, but the process of creating one can be useful.

Learn More
Capitalization Table (Cap Table)

A Capitalization Table or Cap Table is a record of the owners of a company and their ownership percentage of the securities issued by the company. It is typically presented in a spreadsheet.

Learn More
Change in Control

A Change in Control (or Change of Control) transaction is one whereby the owners of a company prior to a transaction no longer own a majority of the shares after the transaction.

Learn More
Churn Rate

Churn Rate is the loss of future revenue due to the loss of a customer/subscription. There are two types of churn: Gross Churn and Net Revenue Churn.

Gross Churn: MRR lost in a given month/MRR at the beginning of the month
Net Churn: (MRR lost minus MRR from upsells) in a given month/MRR at the beginning of the month

Learn More
Common Stock

Common Stock is an equity ownership in a company. Common stock is typically issued before any other type of equity. Once a company has raised capital, common stock typically has junior liquidation and distribution rights to other stockholders and creditors.

Learn More
Convertible Note

A Convertible Note is short-term debt that converts into equity, typically in conjunction with a financing round. By using a convertible note, the investor would be loaning money to a startup, and instead of a return in the form of principal with interest, the investor would receive equity in the startup.

Learn More
Conversion Discount

A Conversion Discount is when the holder of a convertible note has a right to convert into a subsequent financing round or transaction at a “discount” to the price per share of that round.

Learn More
Down Round

A Down Round is a round of financing when the startup is at a lower valuation than the valuation placed upon the startup by earlier investors.

Learn More

Dilution is the reduction in ownership percentage of a share of stock caused by the issuance of new stock.

Learn More
Due Diligence

Due Diligence is the process an investor goes through prior to making an investment in a company. This typically includes meeting and interviewing the founders and key stakeholders, reviewing company documents and financials, and interviewing customers, when applicable.

Learn More
Early-Stage Financing

Early-Stage Financing refers to investments that happen early in a company’s lifecycle.

Learn More

Equity broadly refers to the ownership of a company, which can be represented by stock or other units of ownership. When an investor has ownership of a company, he or she has equity in the company.

Learn More
Flat Round

A Flat Round is a round of financing with the same post-money valuation as that of the previous financing round.

Learn More
Form D

Form D is an SEC filing form used to file a notice of an exempt offering with the SEC. The exemption is found under Regulation D of the SEC. Form Ds are serious stuff; make sure you’re discussing with your attorney.

Learn More
Institutional Investor

An Institutional Investor is an entity with large amounts of resources that invests significant amounts of money on behalf of individuals and companies. Institutional investors are typically investment companies, mutual funds, brokerages, and insurance companies.

Learn More
Hockey Stick Chart

A Hockey Stick Chart is a line chart in which a sharp increase or decrease occurs over a period of time. Hockey Stick refers to the shape of a graph showing a dramatic increase or decrease in revenue.

Learn More
Market Terms

Market Terms are terms in an agreement that are standard or “market.” In regard to venture capital agreements, most startups and investors use and as a baseline for setting terms for those rounds.

Learn More

Multiples is a valuation method of companies. A company’s value will be expressed by multiplying certain metrics like net income or revenue and comparing them against what public and private companies’ values were with similar multiples. If a similar public or private company is worth a certain multiple times revenue, then the company’s value will be similar. A private company’s valuation, however, will be lower due to the shares not having as great of a market as public companies.

Learn More
Preferred Stock

Preferred Stock is a type of equity security that is preferred or has preferences over the common stock, largely in terms of dividend payments and fixed payments upon a corporation’s liquidation.

Learn More
Price Cap

A Price Cap, also known as a Conversion Cap or Valuation Cap, is the greatest valuation used to convert a convertible note into equity in the company.

Learn More
Purchase Agreement

A Purchase Agreement is an agreement that memorializes the sale and purchase of property. Startups are often involved in many purchase agreements, including Asset Purchase Agreements, Membership Interest Purchase Agreements, Stock Purchase Agreements, Equity Purchase Agreements, etc.

Learn More
Regulation D (Reg D)

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. The exemptions are commonly known as Regulation D, and the ’33 Act contains three rules (Rule 504, Rule 505, Rule 506) which provide exemptions from the registration requirement, allowing some companies to offer and sell their securities without having to register the securities with the SEC. (You might still be subject to state security clauses and anti-fraud clauses, even if you do have exemptions). Please consult with an attorney.

Learn More

Revenue is money that is brought into a company by its business activities (typically from sales).

Learn More

SAFE is an acronym for “simple agreement for future equity,” which is an alternative to the issuance of convertible debt.

Learn More

A Security is used to describe a tradable asset of any kind and generally represents an interest of equity in a company. Stock, membership units, and convertible notes are all forms of a security.

Learn More
Series A Round

A Series A Round is generally the first significant capital funding event taken on by a startup, usually after that startup has raised some initial capital through a Friends and Family round, Seed round, or both. In a Series A round, the stock issued will typically be preferred stock designated as Series A stock. You may also hear this financing event referred to simply as an “A Round.”

Learn More
Series A Preferred Stock

Series A Preferred Stock is the class of stock that is issued to investors in a Series A round. The stock is preferred because it contains certain rights superior to the company’s common stock, commonly liquidation preference, anti-dilution protection, and control rights.

Learn More
Sophisticated Investor

Sophisticated Investors are, in essence, investors who are capable of fending for themselves in a prospective transaction. The term is most often used in the context of discussions about whether a private securities offering qualifies for an exemption from registration under federal and state securities law.

In order to qualify for the Rule 506(b) exemption, for instance, the SEC requires all non-accredited investors to be sophisticated. For the purposes of Rule 506(b), the SEC defines a sophisticated investor as an investor possessing sufficient knowledge and experience in financial and business matters to be capable of evaluating the merits and risks of the prospective investment. 

Learn More

Valuation is the process of determining a company’s worth. Valuations can be determined as multiplies of the company’s metrics or comparisons to other companies that recently valued at certain amounts.

Learn More
Other Podcasts in this Series
1 of 15 Preparing for Funding
Preparing for Funding Ep1: Incorporation
2 of 15 Preparing for Funding
Preparing for Funding Ep2: Founders Agreements
3 of 15 Office Hours
Preparing for Funding Ep3: Friends & Family Funding
4 of 15 Preparing for Funding
Preparing for Funding Ep4: Pitch Decks
5 of 15 Office Hours
Preparing for Funding Ep5: Initial Sophisticated Investors
6 of 15 Office Hours
Preparing for Funding Ep6: Accelerators / Incubators
7 of 15 Office Hours
Preparing for Funding Ep7: Seed Round
8 of 15 Office Hours
Preparing for Funding Overview
9 of 15 Office Hours
Preparing for Funding Ep1: Incorporation – Recut
10 of 15 Office Hours
Preparing for Funding Ep2: Founders’ Agreements – Recut