If you’re not bootstrapping yourself, or even if you are, the first place you look for third party financing is with your friends and family. Makes sense. They trust you and want to support you, and you trust them and will do all that you can to make them proud.

The one area which used to be difficult in friends and family financing was valuing the company. If they were putting in $100K collectively, did that give them 2%, 10% or 25% of the company? To put it another way, was the company worth $5 million, $1 million or $400K? Precisely because of the close personal relationship between those bargaining, the agreed valuations were notoriously unreliable.

Enter convertible notes. Essentially these defer the valuation decision until more professional investors are involved. They have no problem fighting it out with the founders, and neither side has any reserves based on their personal relationships.

Friends and Family initially loan the corporation money, on favorable terms, and with no meaningful security of being repaid. The loan converts into equity when a professional financing occurs, at a predetermined rate which gives friends and family more shares for their buck than the later investors. The investors accept that disparity because friends and family took more of a risk by investing earlier.

Doing a convertible note deal involves:

(i) deciding whether the investors will have a rep on the Board. Normally, friends and family do not feel competent to assume such a role. But at times, someone wants to. To be discussed

(ii) a Note Purchase Agreement covering the sale of the Notes by the corporation to participating friends and family. This needs to alert the investors to some risks of the corporation, although the fact that it’s an early-stage start-up makes the whole investment very risky. To be discussed. This is signed by all investors and the corporation

(iii) the Convertible Notes themselves made by the corporation to each investor

(iv) some form of Investor Rights Agreement. What’s in here depends to some degree on the status of the corporation, but the basic functions of this Agreement are similar to those of the Shareholders Agreement described above

(v) Board minutes approving the deal, and in particular the terms of the Notes. Various administrative formalities, including creating the stock certificates and State “blue sky” filings.