The “3Fs”: Good or Bad?

3Fs: Good or Bad?

3F by MIKI Yoshihito via Flickr

The 3F’s are the three largest sources of funding for both entrepreneurs and start-up companies. Each F stands for three different things: friends, family and fools. Research conducted in 2010 by businessinsider.com showed that friends and family invest almost three times more per year than traditional Venture Capitalists. The total invested by friends and family was around $60 billion whereas traditional venture capital funds, state funds, and angel investors only invested $21 billion in entrepreneurs and start-ups. An astonishing 87% of all funding of private companies in the US comes from friends and family as opposed to other means.

There are a couple of reasons why using the 3F’s can seem like a great idea. First, it is much easier to get money from people you know because you have already built a relationship with them and have established a certain level of trust. Second, when you want a subsequent round of funding, it may impress some Venture Capitalists and Angel Investors to know that you have previously been able to influence others to invest in your business. However, not all Angels and VCs share this sentiment.

Conversely, there are many more reasons why the three 3F’s are a bad idea. You can’t run a successful business from guilt, but you’ll need to be prepared for tension at family dinners when the future of your business looks uncertain. None of the 3F’s are professional investors. Therefore many of them do not understand the risk or the time scales involved. You will probably be bombarded with a series of questions every time you see your investor; asking you when they will see a return on their investment and asking you questions about your business. The unfortunate truth is that many people expect their money to be returned in a very short period of time, and start to get unreasonable if this doesn’t happen. Focusing on the money and not the risks involved with the investment is another huge mistake the 3F’s tend to make.

Most 3F’s investors do not have all the required knowledge to make informed decisions about investments. They automatically assume that you are going to be “the next big thing”, particularly with the growth and success that websites such as Facebook and LinkedIN have seen in the last few years. Starting a business is tough, and you will face many obstacles. A family member or friend that has become a disgruntled investor will not provide you with the emotional support that you need when you start your business. In terms of privacy, it can be you and the people whose personal financial details you will see (such as net worth) may feel uncomfortable with this.

It is also very difficult to determine the appropriate structure and price of an investment with 3F’s. Questions will arise such as: What is fair? What will be mutually beneficial? What will we both be happy with? etc..etc. During bad times when down rounds are necessary, a very awkward situation arises, as the initial 3F’s investors’ will be worthless than they were when they first invested. It’s hard to get quick funding if your original investors are family and friends. Unfortunately, many entrepreneurs tend to treat the 3F’s like investors, when in reality they are family and friends. You must be sure that they are fully aware of the risks; for most of these people it will be the first time they have invested in a business. Through their expertise and experience, a seasoned Angel and VC is much more likely to stick by you when things are tough, whereas family and friends normally start to panic that they won’t get their money back. People that are close to you can quickly become your enemies.

This is very important. If you decide to use family and friends, focus on finding investors that are confident and really believe you and  believes that your business will succeed. Asking someone that you know well to invest in your business can be an excellent decision. This may make them more likely to support you in your venture. However, you must choose carefully, as some 3F’s investors can act in a way that is detrimental to you and your business. Find an investor that is already in business. If you know a friend who has started businesses in the past, not only will they be able to help and support you in the future, but most importantly they understand the risks involved in a start-up or any business for that matter.

Another good investor in the 3F’s category is one who is a happy and loyal customer. They have already shown that they believe in the product or service that you provide. Someone with a high net worth can also be a good investor, as their life will not depend on the success of your business. Wealthy professionals such as doctors may also be a good option, they earn high amounts of money and their profession is their main stream of income. If you know any family or friends that are industry or tech executives, they can be the perfect candidates for investors. They have in-depth knowledge and experience in the industry, they may be able to help, advise you or refer you to useful resources. Previous investors that have been family or friends may also be a great option. They have some investment experience; they understand the risks and the reality of investing.

Action List

  1. If someone can’t afford to lose their investment, DO NOT let them invest in you.
  2. 90% of new businesses fail. Clearly explain the risks involved.
  3. Expectation management is crucial. You’ll quickly lose credibility with those close to you if you make promises that you can’t keep. Some three f investors are becoming disillusioned with the huge IPO valuations in recent months, such as the LinkedIN valuation and sites such as Facebook being valued at tens of billions of dollars. Believe it or not, some three f investors will expect the same results from you, not understanding the work and risk involved in a startup company.
  4. Clearly explain timescales.
  5. Clearly explain that they are not guaranteed a return on their money.
  6. Fully disclosing all necessary details at the earliest possible point will help you to stay guilt-free should the business fail.
  7. Following on from point 5, don’t promise your investors a return that they may never see.
  8. If you want future funding, Angel Investors and Venture Capitalists prefer convertible debt, so they are not weighed down with commitments you have made to earlier investors.
  9. Use a lawyer that specializes in start-ups. The correctly formed legal documents will save you a great deal of potential hassle in the future.

It is important to be open and transparent with your investors. When someone has agreed to invest in you and your business, you should give them regular updates and/or milestones to keep them informed about your progress. Start creating value to your business immediately, this will work in your favour in terms of the investors you already have and for new investors (Angels and VCs) for potential future rounds of investment. Keep in regular contact with your investors and be honest about problems or issues you are having. This will keep them well informed so that they know which direction your business is heading in. The worst thing you can do is not tell them until things have got so bad that you have no other option.

 

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