Friends and family are a common source of initial investment, but their presence as shareholders can cause havoc when you try to raise additional capital.
Friends and family might be good for a summer barbecue, but they can cause havoc in getting funding for a private company.
Entrepreneurs typically use so-called friends-and-family funding early in the development of their company, tapping relatives, co-workers, wealthy acquaintances and business partners for the seed money to get their company started.
It's the kind of jump-start most businesses need: Large venture-capital firms, particularly in these more skeptical times, have been hesitant to back early stage companies. In some ways, friends-and-family funding is the only funding new companies can get.
However, experts warn, such funding often lays land mines that make it more difficult for companies to raise traditional venture money down the line.
"It can render your company unfundable if you don't do it right," said Joe Bartlett, an attorney with Fish & Richardson P.C. in New York.
The most obvious problem stems from valuation. At a company's inception, entrepreneurs generally raise money by selling private-equity stock to early investors. Yet, the value of those shares is subjective, and entrepreneurs tend to be more optimistic about the worth of their business. That means the stock often carries an inflated valuation from the beginning.
That causes problems when venture-capital firms step in. These firms traditionally have a more realistic view of a company's worth - and it's generally far lower than that set initially - and immediately, the next funding round becomes a down round. That's often a bitter pill to swallow for existing investors.
It's getting far more acute nowadays. With the market for initial public offerings all but shut to venture-backed companies, and acquisition activity sparse, private companies have been forced to undergo several venture-funding rounds, with many of these down rounds as well. This drop in valuation hurts the investors at the bottom rung of the funding period - namely the friends and family - the most.
It's pain many of these investors don't always have to endure. By funding at inception, friends-and-family investors are often given special rights, like veto power over transactions. That could scuttle a later funding round, even if such a move might ultimately sink the company, Bartlett said.
"All you need is one guy with a veto right," he said.
Control also becomes an issue when many friends-and-family investors sit on a company's board, said Joanna Rees Gallanter, managing partner of Venture Strategy Partners, a venture firm in San Francisco.
"You could have three or four angel investors and the board," she said. "Try to get them off, and there's trouble."
Most small private companies don't need to have that many directors, Gallanter said. Instead, entrepreneurs might want to create an advisory board instead of a large board of directors, to give their investors some say, but no real governance hurdles that later venture capitalists might balk over.
"Your board should be small and very agile," she said.
Friends-and-family investments don't have to handcuff a company. For example, Gallanter suggested that instead of selling investors equity, the initial funding could be structured as a convertible-debt transactions. This helps remove the problem of setting an artificially high valuation at the first funding, she said.
Companies can also raise money initially through a straight debt sale, although many investors are only in venture funding because of the high-risk, high-return nature of equity investment.
Regardless of how the deal is structured, experts say entrepreneurs will have to get used to the idea that their friends-and-family investors will ultimately get pushed out of the business if they get subsequent funding down the line.
"You can change a lot of things," said Fish & Richardson's Bartlett. "But what you can't change is the fact that a lot of VCs won't want to play until you get these people out."
Mr. Hennessey is news editor at Dow Jones, covering the IPO and private-equity markets.