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Navigating the inclusion of family members in a startup’s cap table is a complex decision with advantages and disadvantages. While family funding can provide initial capital and freedom from external investors’ demands, it introduces unique challenges. Founders must carefully consider the dilution of their shares and the impact on their control. Emotional entanglements and unrealistic expectations can strain family dynamics.
However, with clear communication, proper expectation setting, and defined boundaries, family involvement can be valuable to a startup. By understanding the potential pros and cons, entrepreneurs can make informed decisions about family participation in their cap table, ensuring the best path for their startup’s success.
The Secret Ingredient to a Successful Startup: Your Cap Table
The cap table, or cap table, is one of the most important documents for any startup. It outlines the ownership stakes and equity distribution among a company’s shareholders, including founders, investors, employees, and other parties. For early-stage startups, crafting a thoughtful cap table is critical to long-term success.
Family and Friends Funding Round
Founders often turn to family and friends for initial funding when starting a company. While these personal connections can provide capital to get the business up and running, they also mean including family members and friends in your cap table. This decision should not be taken lightly.
Different Levels of Funding
A startup’s cap table evolves through funding rounds, equity grants, and other share issuances. Early decisions about ownership allocation can have lasting impacts. It may be tempting to provide large stakes to family members who contribute capital, but founders must consider the implications down the road.
Family Shares Dilution
Family members’ shares will dilute as more outside investors come on board. This dilution can reduce founders’ control and create messy dynamics if they own a sizable portion, say over 10-15%. Investors may view family members as “dead weight” on the cap table, valuing their contributions less than a traditional investor’s.
While family funding allows founders to avoid giving up equity to outside investors in the early days, it often comes with strings attached. Family members may feel entitled to have a say in business decisions, creating tension and conflict. Their emotional investment in the company and relationship with the founders can also color their judgment.
What Percent to Give Family Member
Keeping family participation in the cap table modest, around 5% or less, is generally advisable. This allows founders to benefit from family capital and support without the downsides of heavy dilution or loss of control. With open communication and well-set expectations, family members can remain meaningfully involved as mentors or advisors rather than significant equity holders.
A startup’s cap table should be designed to set the company up for growth and success. While family funding may provide the initial capital to get a business off the ground, founders must be strategic about how much equity and control they give away to family members. Taking the benefits of family money without the potential costs is possible with care and caution.
Family Money: A Blessing and a Curse for Startups
While not tied to VC funding, family money has no strings attached. Family investors are unlikely to demand a board seat or equity stake that dilutes the founder’s control. They also have a higher risk tolerance and longer-term outlook than traditional investors.
Cons of Family Funding
However, family funding also brings its own set of challenges. When business and family become entangled, emotions tend to run high. There is a tendency for family investors to feel entitled to weigh in on business decisions, even if they have no experience to justify that input. Saying no to a family member’s suggestion or request can be awkward and tense for a founder. Family members may also have unrealistic expectations about the timelines for payoff or the likelihood of success. This can put extra pressure and stress on the founder.
Complicating Family Relationships
Family participation in the cap table also risks the family dynamic itself. Money has a way of complicating even the closest of relationships. If the business struggles or fails, it can lead to finger-pointing and damaged relationships. Family members may resent the founder for losing their investment or feel the founder took advantage of them. The founder may equally resent family members for the added pressures and expectations that came with their funding.
Of course, these risks can be mitigated with open communication and proper expectation setting. But entrepreneurs need to go in with eyes open to the potential downsides of family funding. For some, the benefits of family support far outweigh the costs.
Dilution Dangers – Losing Control of Your Company
When you accept funding from family members in exchange for equity, you risk diluting your share of ownership in the company. While any outside investment necessarily means giving up some portion of equity, family funding brings unique challenges. There may be pressure to provide family members with a more significant stake than would be justified based on the amount invested. This is especially risky if multiple family members want to participate, quickly eating into your control.
Future Funding Rounds Could be Affected
Even if you initially give each family member a small amount of equity, their shares can balloon over time through subsequent funding rounds. Your family may feel they deserve to participate in future rounds to avoid the dilution of their shares. However, new professional investors will likely value the company higher now that it is less risky, requiring you to give up more equity for less money. Your family has a much larger share of the pie despite contributing little additional value.
Loss of Control
Loss of control is a real possibility in this scenario. While you envisioned being CEO for the lifetime of your startup, you may find family members’ voices growing louder and more critical over time. They may insist on having representation on the board of directors or even try to oust you from leadership. This is an unfortunate but common outcome when business and family mix.
Establish Clear Rules
The key is establishing clear rules around equity and control from the beginning. Only provide equity to family members who will add real value, and cap their shares at a reasonable level, e.g., 10-15% for a seed round. Be transparent that their shares may be diluted in future rounds if they contribute less capital. Also, include provisions guaranteeing your position as CEO and primary decision maker. Get everything in legally-binding contracts to avoid confusion and hurt feelings down the line. With suitable safeguards, you can benefit from family funding without losing control of your startup.
Can Your Family Survive Your Startup? Tales of Relationships on the Rocks
Bringing family into your startup’s cap table is risky and can strain relationships. When business and family collide, tensions are bound to rise. Your brother may feel resentful if you have to turn down his request for another capital injection. Your parents might meddle in crucial business decisions to protect their investment.
The E-commerce company Rockets of Awesome was founded by sisters Rachel and Stacey. Early on, they set ground rules to keep family matters separate from business. “We made a pact never to let emotions get in the way of key decisions,” says Rachel. “We also promised to be extremely transparent and overcommunicate with each other.”
Five years later, Rockets of Awesome has raised over $12 million, and the sisters’ relationship remains intact. Their secret? In addition to setting boundaries, they try to show appreciation for each other. “We end every board meeting by giving gratitude for something the other person did that helped the business,” says Stacey.
For any startup, communication, and trust are vital. For family-funded companies, they’re essential. Families can navigate the startup journey with open conversations and mutual understanding without jeopardizing relationships. There will always be an element of risk, and in some cases staying out of the cap table altogether is the safest option.
Setting Clear Expectations – The Key to Success
Setting clear expectations upfront is critical to successfully including family members in your startup’s cap table. Have an honest conversation about the risks and rewards of their investment before any money changes hands.
Discuss the Business’s Best-case and Worst-case Scenarios
Some of the key points to cover include:
- Their investment may only be recovered if the business succeeds. Make it clear that startup investing is risky, and there is a chance they may lose all the money they put in. They need to go in prepared for that outcome.
- They will own equity but may not have control. Discuss the amount of equity they will hold and what that means in terms of management and decision-making power. They need to be comfortable in a minority ownership position.
- There may be dilution in the future. Explain that future investment rounds may dilute their ownership stake. Get their approval for potential future dilution so they feel confident and confident later on.
- The business may struggle at times. Highlight that startups face ups and downs and must be in it for the long haul. Ensure they understand the company may go through difficult periods, and they need to maintain confidence in the team.
- Their investment is illiquid. Explain that as startup shareholders, their investment will be illiquid, meaning challenging to sell or cash out. They must be comfortable holding their equity long-term, potentially 5-10 years or more.
- Set rules for resolving disputes. Establish a shareholders’ agreement that details how disputes will be settled to avoid family drama. Consider including a mediation or arbitration clause with an independent party to defuse tensions.
Family Members Can Be Startup Champions For Your Business
With open communication and the right expectations set upfront, family members can become champions of your business and provide more than just financial support. But make sure to address all the potential issues before they become problems. With family, an ounce of prevention is worth a pound of cure.
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