It is highly typical for a startup to have small investors on its cap table.  Founders often raise money from friends and family and other angels.  That is all well and good….and 100% normal.  Without friends and family and angels there would not be many companies for VCs to look at!

The treatment of the friends, family and angels (FFA) as the startup matures and raises larger rounds of financing over time is interesting.  And sometimes founders want to protect the financial interests of FFAs.  This is completely understandable but not always possible.  Here is a quick guide.

1.  If FFAs only invest at the beginning and do not make any follow on investments as the company raises more $$ then the only real way FFAs make money when the company is ultimately sold is if the company keeps raising future rounds at higher and higher valuations (and IPO exit may provide upside if the stock price increases over time after the IPO).  In this situation, the FFAs are diluted from an ownership percentage, but enhanced economically.  In short, they own a smaller piece of a larger valuation pie.   In my experience, this works about 1 out of 20 times. So not very good odds.  Startups often get stuck, restart, pivot/change/move, etc., causing valuation bumps.  Or the economy tanks or stock market tanks moving valuations down at inopportune times for the startup.
2.  So, the best thing for FFAs is to continue to invest, particularly in down rounds (where the price per share is lower than previous round).  When asked, I always give the same advice:  if you are investing $1 today, reserve $2 for future rounds because you never know what is going to happen.
3. If FFAs do not continue to invest and the company hits bumps (again – this is the norm), then the company ends up with unhappy FFAs and the founders feel responsible (understandably so).  The weight of this responsibility is very real.

So, do VCs care about the FFAs?  Sure, we care about prior investors.  We have even done deals where we come in for a Series A or Series Seed at a valuation LOWER than what the FFAs paid, and then literally convert the FFAs investment to the lower valuation security to protect them.  Personally, I like everyone to be on the same page starting out.

But once we invest, do we care about protecting FFAs?  The short answer is that we completely believe that ALL investors (including FFAs) should have preemptive rights (just the right to invest in future rounds on a pro rata basis).  And as stated above, I think they should use these rights.  But if they do not use them and do not invest in future rounds then it is challenging for participating investors to be very concerned about non-participants’ dilution.

Also, note that the Board of Directors of any company owes the same fiduciary duties to all shareholders.  So when faced with a choice of approving a down round (typically bad for non-participants) or seeing a company go under for lack for financing, the director’s choice is not typically difficult.  It is better for all shareholders to fund the company.

Anyway, lots of interesting dynamics.