Early in the fundraising process, many entrepreneurs avail themselves of the traditional 3F’s (friends, family and fools) to raise that early capital. While this is a legitimate and valid process, it does not mean that it shouldn’t be treated as a formal legal arrangement.
Sometimes, entrepreneurs are highly successful in raising capital from a number of close acquaintances. This gets to be a problem when you start to raise equity based capital from angels or venture capitalists. Rather than dealing with a single owner, there are in fact many individual owners who may all have different assumptions and expectations. While some investors will give you enough time to clean up your cap table, it can be enough for other investors to pass altogether. The time to keep this all clean is the first time you take on capital from a friend or family member. You need to treat the transaction like any other legal contract spelling out terms and rights.