Friends and Family Rounds: What You're Actually Asking Them to Sign

We have been on both sides of a friends and family investment. We have received capital from people who trusted us, and we have put capital into a company run by people we trusted. The experience on both sides was the same: the transaction was not fully understood by either party at the time it happened.

The founders explained the idea well. They did not explain what would happen to the investment if the company failed, which it did.

What you are actually offering

Friends and family capital can take several forms, and the form determines what your investors are actually receiving.

A loan is a loan. The investor lends money, the company agrees to repay it with or without interest, and the repayment terms are specified. If the company fails, the loan is a creditor claim against the company's remaining assets. In most cases, a failed startup has no remaining assets worth recovering. The investor gets nothing.

Equity is an ownership stake. The investor receives a percentage of the company in exchange for capital. If the company succeeds and is sold or goes public, the equity may be worth something. If the company fails, the equity is worth nothing. The investor has no repayment right. They participated in the outcome, positive or negative.

A convertible note is a loan that converts to equity at a future financing event. The investor lends money, the loan accrues interest, and when the company raises a priced round from institutional investors, the note converts to equity at a discount to the round price. If no financing event occurs and the note matures, the company owes the principal plus interest. If the company fails before the note converts, the investor is a creditor with a loan claim, which is often worth nothing in practice.

A SAFE (Simple Agreement for Future Equity) is similar in structure to a convertible note without the interest and maturity date. The investor gives the company money now in exchange for a right to receive equity in a future priced round. If no priced round occurs, the SAFE may never convert. If the company fails, the SAFE holder has no repayment right.

What most participants don't understand

The people who invest in a friends and family round typically do not understand the difference between these structures and often do not understand that equity and debt have fundamentally different outcomes in a failure scenario. A friend who gives you $25,000 in a friends and family round often believes, implicitly, that they will get the money back if things do not work out. In most structures, they will not.

This is not a reason not to raise from friends and family. It is a reason to be explicit about what is being offered, in writing and in conversation, before anyone writes a check. The conversation that says "if this company fails, this money is gone, and here is why" is uncomfortable and important. Most founders do not have it. The people who invested and did not get it back remember.

What the tax consequences can be

A loss on an investment in a company that fails may be deductible, depending on how the investment was structured and the investor's tax situation. Section 1244 stock allows investors in qualifying small business corporations to claim an ordinary loss, rather than a capital loss, on stock that becomes worthless. This is a meaningful difference because ordinary losses offset ordinary income, while capital losses can only offset capital gains plus $3,000 of ordinary income per year.

The rules for qualifying as 1244 stock are specific and require advance planning. This is not something you retrofit after the company fails. It requires the right structure at the time of investment. An attorney or CPA can confirm whether your offering qualifies. Mentioning it to your investors as part of the conversation about what they are getting is worth doing.

The relationship cost

The financial outcomes are the measurable part. The relationship cost of a friends and family round that goes badly is not measurable and is not recoverable in the way that a financial loss sometimes is.

We have seen this resolve well: investors who understood the risk, got nothing back, and remained in the relationship because the founders had been honest about what they were asking. We have seen it resolve badly: investors who did not understand the risk, got nothing back, and felt deceived because they had not understood that was a possible outcome.

The difference was the conversation at the beginning. Most founders do not have it because nobody explains that it is necessary. We are telling you: before anyone writes a check, say plainly what happens if the company fails. Say it even if it is uncomfortable. Especially then.