You have an idea, you’ve validated it, and you’re confident that it has potential. Yet, in order to truly test it, you need to start building – you need a prototype or a minimum viable product. Моrе often than not this requires at least some capital investment in your startup project.
Most new companies are funded by the founders – either from their savings or from business loans. For traditional businesses with predictable cash-flows, bank loans are a great source of finance since they provide you with leverage – you don’t dilute your share in the business, and in the long run, you can earn more money.
If you are building a startup, however, funding your business with credit is way too risky. You’ll have to return the credit no matter if your idea works out or not, and because of the very high startup failure rates (over 90%), this is, unfortunately, the more likely outcome.
That’s why most startups are bootstrapped by the founders in the very early stages. If you don’t have enough savings to cover the costs of developing your first product versions, however, you’ll have to fundraise.
Yet, fundraising among angel investors and venture capital funds at such an early stage is not a viable option. Nowadays professional startup investors are more sophisticated, and they know that idea-stage startups are way too risky. Investors usually want to see some kind of solid proof that the company is on the right path to product-market fit. In other words, investors want to see some kind of traction before they risk their money, however, in order to gain traction you need money to develop the first version of your product – a catch-22.
If you don’t have enough money to cover the needs of your new business and banks and startup investors are not an option, then your last hope is friends or family. If you are lucky enough to have people in your life who are willing to support your business venture, this seems like a win-win situation. Needless to say, however, risking the hard-earned money of your loved ones is not a decision to be made lightly.
The very first pre-seed investment round is often jokingly called in the startup community the FFF round – fools, friends, and family. Fools, because you’d invest in such an early-stage project only if you don’t understand the level of the involved risk. The expected return of such investments on average might be negative.
This doesn’t necessarily mean that your friends and family are fools, however. Such investment for them has a higher value than it would have for an outside investor because these people are already personally invested in your life and your success. For example, from the viewpoint of the parents of the founder, even if the expected return of the investment is negative, this could be justified as an expense for the personal growth and development of the founder – the experience of building a startup from scratch would be valuable for the professional future of the founder even if the project fails.
Moreover, the real upside is higher, because the parents don’t care only for their own return, but for the ability of their child to support themselves by doing something they love. For example, if the startup idea isn’t scalable and doesn’t become a unicorn, but rather transforms into a lifestyle business, an angel investor or a venture capital fund would write it off as a failed investment. However, parents would likely be perfectly happy to help their child start a small family business even if their investment doesn’t result in a 10x return.
This is the ideal scenario. However, if the friends and family investors don’t fully understand the implications of their decision to give you money for your project, losing their money could cost you relationships. This is a terrible situation to be in – a failed startup is very hard on the founders, but if it comes together with damaged relationships the emotional cost would be even higher.
Consequently, you shouldn’t be afraid to take an early-stage investment from friends and family. However, you need to make sure that they are not also fools. They need to understand well the implications of their investment – the likelihood that the money will be lost. If your friends and family can’t afford to invest in your project, then it’s better not to take their money but to search for other options.