What Are Friends and Family Shares?
The term friends and family shares refers to stock offered by a new business to friends, family members, or other associates of the company's executives. These shares are usually one of the very first sources of capital for a young business entity. Entrepreneurs, issuers, and bankers may offer these shares to those close to them before the stock is offered to the public through an initial public offering (IPO). These shares give friends and family a stake in the future success of the company.
- Friends and family shares are offered to friends, family members, or other business associates of a new company's executives.
- Entrepreneurs, issuers, and bankers may offer these shares to those close to them before the stock is offered to the public through an initial public offering.
- Many entrepreneurs have trouble finding viable sources of capital, so they turn to friends and family by offering them a stake in their company.
- The Securities and Exchange Commission has rules on how companies are able to issue shares including to friends and family.
Understanding Friends and Family Shares
As mentioned above, friends and family shares are offered to people close to the heads of a startup. When it comes time to issue friends and family shares—which are also called directed shares—the lead underwriter for an IPO typically agrees to administer friends and family shares as a service to the issuer. These shares are normally sold to friends and family at a discount from the price set for the IPO. By buying shares, these associates get a stake in the company's success, just like any other shareholder.
The number of shares offered by a company typically represents a small percentage of the company's offering. This is normally less than 5%. But while the number of shares one person holds may be small, they may create significant gains for the holder—especially if the company is successful.
But why do companies issue friends and family shares? It's simple. They may find it difficult to get financing from traditional sources when they're in the startup phase. Banks don't lend debt capital to young businesses if they don't have a history of revenue or assets. Seed money or private equity often comes at too high a cost, such as giving up significant equity ownership. Even before a new business entity reaches the angel stage of raising capital, they often call on friends and family for additional funds to push through to more traditional forms of financing. Friends and family are theoretically more understanding, so they may be more willing to provide capital for speculative purposes.
The idea of seed capital from friends and family is largely an issue for individuals who have considerable financial resources. Entrepreneurs without access to friends and family in higher socioeconomic positions are effectively locked out from this form of financing. But friends and family rounds of financing are not without their drawbacks, as the use of friends and family monies creates the potential for strained relationships. But at times, friends and family may be the best option available. In fact, many companies end up turning to close associates for money because they're more apt to invest their money to fuel the success of the company.
There are a few things new companies need to keep in mind before they issue shares to their friends and family. The Securities and Exchange Commission (SEC) makes rules about how companies can raise money to fund their businesses in the United States. Any company that issues shares to the public—including to friends and family—must register this stock with the SEC. This is the initial registration form before a company goes public in an IPO. Companies are exempt if the investors are all accredited. These are privileged investors based on net worth, asset size, or professional experience.
The annual income for an accredited investor exceeds $200,000 for the last two years and is expected to be the same or higher in the current year.
The SEC also pays close attention to the effects of friends and family shares. That's because of the potential conflict of interest they may create. For instance, some of these shares may be flipped during the IPO, creating large profits for the friends and family shares holders—something regulators frown upon.