In an ideal world, your initial sales would finance your development and expansion. But it isn’t easy, especially when you must develop and manufacture before selling anything. A helping hand is a crucial need for many startups.
And the most accessible sources of early financing are your friends and family. Many founders have friends and family who believe in them. Often, these friends and family are prepared to put their money where their mouth is.
The key question is what portion of the company is their investment worth? The founders want to give their friends and family a fair deal, but who knows what that is? Is a $100,000 investment worth 5% or 50% of the company? This is the heart of the valuation question for early stage startups.
Difficulties in valuing an early stage startup is where Convertible Notes came from. Neither founders nor their families nor friends are qualified to value a start-up. Even professionals can differ as to valuation, and those differences can be stark.
A Convertible Note defers the valuation until such time as professional investors are involved. Friends and family make loans to the company which can convert into equity when professional investors invest and negotiate the startup’s value with its founders.
Typically, upon conversion of the notes, friends and family receive more shares for the same cash than do the professional investors, because the friends and family took more of a risk by investing earlier.
A quick summary of the ups and downs of friends and family rounds, taking into account the human element as well as business issues, is here: http://thepurposeisprofit.com/2015/04/29/the-advantages-and-disadvantages-of-friends-family-funding/ (taken from “The Purpose Is Profit: The Truth about Starting and Building Your Own Business,” available for purchase on Amazon). The authors are Ed McLaughlin, a serial entrepreneur who earned Entrepreneur of the Year honors from Ernst & Young in 2001, and Wyn Lydecker, founder of Upstart Business Planning and a business plan wizard, (yes, you do need one of those!)
I found little more technical guidance, perhaps because these rounds are not a good source of revenue for law firms (not enough money raised to cover law firm fees). Cooley published this helpful comparison between friends and family rounds and professional investor financing rounds: https://www.cooleygo.com/difference-friends-family-seed-series-financings/
Here’s a Quora thread with some interesting tidbits: https://www.quora.com/What-deal-structure-should-be-in-place-for-a-friend-family-investment-of-20k-in-your-startup.