Raising capital is a crucial early step for Australian start-ups. While venture capital or angel investors might come later, many founders turn to their closest circles for initial funding. Raising money from friends and family can be an accessible and supportive way to launch a business, but it also comes with legal and financial risks that should not be overlooked.
Why Do Start-ups Seek Funding from Friends and Family?
Securing funding from traditional investors in the early stages can be challenging. With limited traction and high risk, venture capitalists and banks often hesitate to invest. In contrast, family and friends typically invest based on trust and belief in the founder, rather than financial projections. This trust-based investment can be a valuable stepping stone for start-ups that need capital to prove their concept before approaching institutional investors.
Benefits of Raising Money from Friends and Family
1. Quick Access to Funds
Unlike formal investors, friends and family often provide funds more quickly, without extensive due diligence and negotiations. This speed can be critical for start-ups needing immediate capital to secure opportunities or scale operations.
2. Flexibility and Patience
Family and friend investors may be more forgiving about financial risk and may not be pressured for immediate returns. This flexibility allows founders to focus on growth without the short-term performance pressure that often comes with venture capital funding.
3. Emotional Support
Starting a business is stressful. Having a support system that believes in your vision can be invaluable. The encouragement of close supporters can make a significant difference in a founder’s resilience and motivation, especially during challenging times.
However, despite these benefits, informal investments can create serious challenges.
Risks of Raising Money from Friends and Family
1. Unrealistic Expectations
Many family and friend investors do not fully understand the risks associated with start-ups. They may expect guaranteed returns, leading to disappointment if the business struggles. Clear and honest communication is essential to ensure all parties have realistic expectations about timelines, risks, and potential outcomes.
2. Relationship Strain
If the venture fails, personal relationships can suffer, sometimes leading to resentment or even legal disputes. Navigating financial loss within personal relationships can be complex, making it crucial to have written agreements that outline the terms of the investment or loan.
3. Ambiguity Over Terms
Informal or verbal agreements can lead to misunderstandings about whether the funds are a loan, a gift, or an equity investment. Without proper documentation, founders may face unexpected claims or disputes down the track.
To mitigate these risks, it is crucial to approach family and friend investments with the same legal formality as any other investor.
Legal Considerations for Raising Capital Privately
Disclosure Obligations
Under Australian law, raising funds from investors must comply with the Corporations Act 2001 (Cth). Start-ups must adhere to strict disclosure obligations, such as preparing offer information statements or prospectuses. Non-compliance can result in significant penalties and reputational damage.
However, exemptions exist for small-scale offerings and sophisticated investors (s708 of the Act):
1. Small-Scale Offerings Exemption
- Offers made to fewer than 20 investors in any 12-month period
- Total funds raised must not exceed $2 million
- Investors must have a personal or professional connection with the founder
2. Sophisticated Investor Exemption
- Investors must have net assets of $2.5 million or a gross income of at least $250,000 for the past two financial years
- The minimum investment amount must be at least $500,000
Even if formal disclosure documents are not required, founders must avoid misleading or deceptive conduct (s1041H of the Act). Any statements regarding business growth, profits, or returns must be honest and substantiated.
Investor Protections vs. Consumer Protections
It’s important to note that friends and family investors are generally not protected under the Australian Consumer Law (ACL) in the same way as customers. However, they are still protected by provisions in the Corporations Act, particularly regarding misleading or deceptive conduct and disclosure obligations.
Founders must be transparent and honest about the business’s financial status and prospects. Overpromising returns or misrepresenting the likelihood of success, even unintentionally, can expose the company and its directors to legal liability.
ASIC Licensing Considerations
Do You Need an Australian Financial Services (AFS) Licence?
While early-stage capital raising from friends and family typically falls within legal exemptions, founders should be aware that repeated or widespread fundraising activity may attract regulatory attention.
If you’re promoting investment opportunities to the general public, or if your offers extend beyond the scope of the small-scale offering exemption, you could be deemed to be carrying on a financial services business, which may require an Australian Financial Services (AFS) licence.
Although this is rare for informal, one-off capital raises, it’s important to monitor the scale and method of your fundraising efforts and seek advice if you plan to raise larger amounts or market more broadly.
The Importance of a Shareholder Agreement
A well-drafted shareholder agreement protects all parties and prevents future disputes. Key provisions should include:
- Rights and obligations of shareholders
- Share capital structure and voting rights
- Minority shareholder protections
- Dividend entitlements
- Exit rights and dispute resolution mechanisms
Having a formal agreement ensures clarity on decision-making processes, ownership rights, and expectations for financial returns.
Dos and Don’ts of Raising Capital from Friends and Family
Dos
- Have a Formal Agreement: Clearly document the terms using a shareholder agreement, loan contract, or convertible note deed.
- Ensure Everyone Understands the Risks: Provide a written risk disclosure document and avoid making unrealistic promises.
- Consider Independent Legal Advice: Encourage investors to seek independent legal advice to fully understand their rights and obligations.
Don’ts
- Do Not Rely on Verbal Promises: All terms must be in writing to avoid misunderstandings.
- Do Not Accept Funds Without Clear Documentation: Clearly define whether funds are a loan, gift, or equity investment.
- Avoid Mixing Business and Personal Finances: Clearly separate personal relationships from business transactions to maintain professionalism.
Structuring the Investment
Loans
Loans are a simple way to raise funds while retaining full control of the business. However, they require formal loan agreements specifying:
- Repayment schedules
- Interest rates
- Security (if applicable)
Loans should include clear terms regarding repayment obligations, interest calculations, and consequences of default to avoid future disputes.
Equity, Convertible Notes, and SAFEs
Instead of loans, founders can offer equity, convertible notes, or Simple Agreements for Future Equity (SAFEs). These investment structures allow investors to convert funds into shares at a later stage, offering flexibility for early-stage fundraising.
Founders must ensure compliance with ASIC regulations when issuing shares and understand that equity financing can dilute their control over time. Convertible notes and SAFEs are particularly useful for structuring investments where valuation is uncertain at the early stages.
Tax Considerations
- Equity investors may be subject to capital gains tax (CGT) upon the sale of shares.
- Any loan interest received may be taxable to the lender.
- Investors should clarify whether returns will come from dividends, capital appreciation, or both.
- Founders should also be aware of fringe benefits tax (FBT) implications if loans are provided on concessional terms.
Final Thoughts
Raising money from friends and family can be an effective way to fund a start-up, but it must be done professionally and transparently. Legal safeguards, clear communication, and proper documentation are crucial to avoid conflicts.
A handshake is not a strategy! AÂ well-drafted agreement is.
If you are considering raising capital from friends and family, consult Allied Legal early to ensure your investment structure complies with ASIC requirements and the Corporations Act while protecting your business and relationships.
