Family money, now how much ownership do I give them?

You have a few options.

One option, the one the VC described, is known as a convertible loan. The money your family gave you converts to stock in the company at some future round of financing at a discounted price. There are certain pros and cons to this structure, but one thing to consider immediately is whether or not you plan to take future rounds of financing. If the answer is no, then a convertible may not be the best answer.

Another choice is preferred stock. Creating preferred stock is a time-consuming process that requires added documentation. If your family isn't asking for preferred stock, then you might not want to worry about it.

That leaves just giving your family straight ownership. This is the simplest solution. Yes, valuing your company is tough at this stage, and you don't want to give your family tax obligations by valuing the company too high. Consider selling them shares at par value, and then have them make a capital contribution to the company. Also, simple anti-dilution provisions could be used to give your family some protection in the event you take a future round of financing.

Protect and hold your equity.

I recently had this conversation with my accountant. He advised I treat family investments as a long-term debt to be paid back with interest.

I have also gathered this same advice from several entrepreneurial-type books I've read. For example, the author of The Toilet Paper Entrepreneur states, "a fool and his equity are soon parted."

An excerpt from the aforementioned title in Chapter 10 - Keep Your Business To Yourself, reads:

If you have or plan to have a child, would you give a portion of your parental rights to your friend, your neighbor or the doctor at the local hospital? I hope you're thinking NO FREAKING WAY. It's your kid for God's sake! Your kid, Jeez!

A child requires a tremendous amount of your time to feed, nurture, train, and keep healthy so he'll stop puking on you. But watching your kid grow is MORE than worth it. Guess what, Chiefy? Your business is YOUR baby! While it doesn't look like much now you will be putting a tremendous amount of time, tears, and sweat into it. As with a baby, you will need to feed and nurture your business, keep it healthy, and teach it not to vomit on you. As your newborn business grows, it will slowly but surely turn into a strong, healthy young adult. It would be a shame for you to do all that grueling work only to be sharing the parental rights when the business starts hitting its stride. So don't do it - don't give your baby away.

If you give away chunks of your business every time someone writes you a check, you may soon be owned and lose control over your venture. It is the easy and low-cost option right now, but think about the long-term consequences.

I would think that they are helping you with little hope of return, you should do what you can to ensure that they get back, potentially, more than they gave you, since they are taking such a large risk.

You may want to just give them some percentage of the company, perhaps 20%, which seems high, but it would mean that for the financial risks you still control 80% at the moment.

Later, if you get VC funding you might be able to pay them back some, and get back some percentage of the company to give to the VC.

Personally, I would ensure I would be more than fair, as family taking a risk is a lot more personal than a VC, since they are doing it because of blind belief in you. A company should not come between family.

If someone dies, then their kin should get the percentage, IMO.

The convertible note approach suggested by your VC contact is fairly common with our early stage clients as a means of raising a "friends and family" round, particularly where it is difficult to determine valuation.

Orrick has a good overview on convertible notes on their Total Access website:

It really depends on how much money you took from your family. First thing is to find out if they want it as debt or equity. A family debt is a personal loan that you'll have to pay back even it the venture flops. The VC's recommendation is pretty sound. At least they know that they received fair value for taking any risk.

The convertible debt advice is good. I wrote a blog post about whether to price a round or take convertible debt.