Advantages and disadvantages of funds from Family and Friends

Advantages

• Family and friends know your capabilities and are willing to invest in your dreams.
• If your business works out, the people closest to you also benefit.
• You are most likely to turn to family and friends for help and advice, and it is better if they have a financial stake in your business.
• If the funds are a loan, you have an option not repay it because your friend or family will "understand". With a bank loan, you must pay each month.

Disadvantages

• By investing in the business, your family and friends will consider their opinions to be just as valid as yours.
• If your business closes and they do not re-coup their money, your key relationships may suffer.
• If the funding isn't documented properly loan or equity, your books can get "messy" and hinder you from getting other loans.
• If you are offering equity in return for the funding, it may hinder your ability to make business decisions because there is more than one owner.
• If you are a sole proprietorship, offering equity for the funding will complicate your legal structure and subject your investor to legal liability. If you make them a partner, they are legally obligated for all business debts. The only way to protect them is to incorporate or form an LLC (or take the money as a loan instead).

Selling across state lines

If you are selling securities to people outside your state, you are responsible for complying with SEC rules. Generally, you do not have to file with the SEC if you comply with Regulation D:

• Rule 504: Offering up to $1 million in securities within a 12 month period. You may not publicly advertise. Unless you sell exclusively to "accredited investors" (they have net worth over $1 million), the securities must be "restricted" - that means they are not to be resold. This restriction should be stated on the stock certificate.
• Rule 505: Offering up to $5 million in securities to accredited and up to 35 non-accredited investors. You may not publicly advertise. The security is purchased for investment, not the intention to resell. Purchasers cannot be sell the security within a 12 month period (this should be stated on the stock certificate). You must provide audited financial statements.
• Rule 506: Unlimited offering in securities to accredited and up to 35 "sophisticated" investors. Sophisticated investors must have sufficient knowledge and experience in financial and business matters to make them capable of evaluating the merits and risks of the prospective investment. You must provide audited financial statements.

Click here for more information about SEC filings

Partnership or Loan?

It is critical that you decide whether the funds are to be repaid. If yes, this is a loan and it should be put in your business' balance sheet as a liability. You should document the loan (even in a letter) with the interest rate and repayment schedule.

If funds are not to be repaid, the funds are either a gift or a partnership investment. Unfortunately, setting up a partnership investment has complications. Partners have the same liability as the owner, unless you form a limited partnership, a corporation or an LLC. That means if the business fails, the partners will use their personal assets to pay any business debts. Unless the partner is involved with the day-to-day operations, most people would not agree to this.

To solve this problem, you can get creative and set it up as a loan, with payment terms be based on the company's net revenue. Then document it as a liability on your balance sheet.

If you set up a partnership, limited partnership, corporation or LLC:

• Document the partnership and clearly show the percentage ownership.
• Provide regular information (reports, financial information) to your partner
• File taxes as a partnership and pay your partner his/her percentage

Funds from Friends of Friends

To avoid criminal securities violations, you should NEVER publicly advertise the stock and only seek funds from people you directly know. Otherwise, you should work with an attorney to make sure you are following securities laws.

An attorney can help you do a private placement, which allows you to sell ownership interests to "accredited investors" (people with over $1,000,000 in personal wealth).

Never advertise ownership interests to the general public. This is a serious violation of SEC (Securities and Exchange) rules.

If you sell a security, you are responsible for complying with your state's securities regulations. Usually for small transactions there is a simple form to complete (or no form).

Best Practices

• Provide full disclosure of your business - your strategy, your operations, and your financial information.
• Document the agreement as a loan or as an equity investment, ideally with help from an attorney.
• Have full disclosure on your plans for the business and your expectations for the future.

Ongoing Responsibilities

• Provide ongoing disclosure of your business - your strategy, your operations and your financial information.
• Do not mix personal and business assets or money. Keep your books clean and up-to-date.
• If it is a loan, repay it per your agreement and document any changes to that agreement.