Guide to Raising Money with Informal Investors

Many entrepreneurs - for a variety of reasons - choose informal investing over more traditional methods. Informal investing is the process of procuring financing through people that you know, such as friends and family, rather than through a bank or credit union. This works rather well for many start-up businesses because they feel more comfortable dealing with those they know rather than owing large sums of money to a formal lender. However, there are some things you should know about raising money with informal investors.

Raising Money with Informal Investors: Beware Pro-Rate Rights

When early investors - those who get in the game when your business is just starting out - might attempt to negotiate pro-rata rights, which used to be uncommon among informal investors. However, if your investor is working with an attorney, this issue will most likely come up. The problem with pro-rata rights is that it gives early investors security by guaranteeing them ownership through future investments, but it will also entice future investors to want the same thing. Before you know it, your company will be overrun by those with pro-rata rights, and you won't be able to get out of it. Although it is mainly an attempt by early informal investors to secure their stake in your company, you should tread lightly when approaching this issue.

Raising Money with Informal Investors: Beware Giving Away Rights

As grateful as you might be to your informal investors, you have to remember what they say about too many cooks. Investors - whether informal or institutional - will want to have their hands in everything concerning your business, which will complicate your ability to make future decisions. For example, let's say that you have four informal investors who all require you to submit quarterly reports, to get their signatures on financial documents and to consult them about financial decisions. Before you know it, half of your workweek will be spent keeping investors in the loop, and you'll have no time left over for running your business.

Raising Money with Informal Investors: Beware Management Compensation Limits

Some investors will require that you place a limit on how much your employees can earn, which can really create a problem for you. For example, let's say that your informal investors have placed a cap on compensation at $26,000 per year. This means that when your top employees have reached that level, they will have absolutely no room for growth, and they will seek employment elsewhere. This is a situation that requires you to look out for those who work for you. Suggest instead that you put together a compensation committee to review salary and wages each quarter. Let your investors know that you are all about budgeting, but that you want to take care of your people.

Raising Money with Informal Investors: Request a Cure Period

Just because your investors are friends and family doesn't mean that they won't require the same legal provisions as institutional investors. Most investment contracts have a clause that requires the business owner to remain compliant with all laws and regulations pertaining to business. For example, if you were to enter into an illegal contract with a vendor, you could be found in default of the investment contract and lose your funding. To guard against this potential calamity, request a cure period in the contract (two to six weeks is appropriate). This gives you time to rectify a problem if you are found to be in default of your contract.