For an entrepreneur capitalization tables (“cap tables”) are amongst the most important documents to understand. A cap table lays out who the shareholders are in a company and how many shares they own. Although this sounds like a simple exercise, it can grow increasingly complex when a company matures to keep track of all shareholder information, ownership positions, rights to purchase additional equity in the future, vesting schedules, voting percentages, share prices and preference clauses. Besides, rather than being a plain register, the cap table is an important decision-making tool in key events evolving around financing, ownership and exit. This is also the reason that investors closely evaluate a venture’s cap table as part of the financing process and there are number of ways its makeup can be a deterrent to investors (also called a “broken cap table”). In this blog post we will walk through the most critical elements to help founders effectively manage their cap table.
One of the biggest issues, by far, is too small of an ownership by the founding team. An inexperienced founder who is eager to bring in the first equity investment might give up too much equity too soon – be it to angel investors or via several “seed” rounds. In a later stage this might turn out to be a hurdle for new investors as it raises doubt whether the founders still have sufficient incentive to perform at their peak. Although there are no hard criteria, a rule-of-thumb is that a venture is entering the danger zone when post the seed round the founding team (incl. ESOP) owns less than 50% and/or the CEO owns less than 10%. Simple ways to prevent this is to be diligent about dilution in the early-stages of the company and limit the number of bridge rounds (i.e. raise adequate amounts).
Dead equity is defined as significant equity stakes (>2%) that are owned by either founders, management or advisors who are no longer involved with the company. Granted equity stakes to persons that are not actively growing the company easily leads to misalignment amongst management and thus becomes a problem to investors. Luckily, dead equity is easily prevented by including the right terms and conditions in the shareholders documentation such as vesting schemes or buyback provisions. Also try to prevent giving away equity stakes to third parties for one-off contributions.
NO. OF INVESTORS
When it comes to cap tables “the more the merrier” is not commonly heard saying. Large numbers of investors (20+) can be a huge distraction, especially if a founder has to spent a crushing amount of time chasing signatures, aligning interests and informing all parties. New investors are usually not interested in participating in a venture who is dealing with these dynamics- also since negotiating future ownership stakes and strategies with lots of small owners entails a significant risk. It is in the founders’ best interest to limit the number of investors on-board and/or pool smaller investors in legal entities with a single representative.
Before making an investment in an early-stage company, investors often request the creation of an option pool. Employee option pools are strong instruments for attracting and retaining the best talents (key employees + C-level), especially in the phase where your venture can not match the blue-chip salaries. To begin with, the option pool would be unallocated (i.e. not given to anybody). As the company grows and hires more people you can allocate options from this pool. When exercised the options will convert in non-voting common shares. Furthermore, expect some discussion with your investors about dilution consequences of installing/expanding an option pool (pre-money vs. post-money).
Rather than just solely looking at the status-quo- the cap table is often used to perform future scenario’s. For VCs considering an investment in a company this usually means they perform a “VC-method” of valuation to validate their participation. Taking in consideration the terminal value of the company (also: “exit value”) and the ROI target of the fund they reversely calculate back to the required stake (%) in the funding round and pre-money valuation. The basics here are quite simple and very useful for a founder to understand to make sure that when formulating a capital request this is in line with investor targets. Please mind however that the math can get quite tricky when factors such as dilution from follow-up rounds, downside protection (i.e. anti-dilution, liquidation preferences) and time-value of money come into play.
When it comes to cap table management we would strongly advise not to play favorites. Although it can be tempting in deal negotiation to go give individual investors something special- these unique terms per investor introduce the risk of complications and misalignment of interests. Some potential future deal breakers are: unusual securities like fixed-dividend shares, 3+ classes of common shares, single investor liquidation preferences and/or multiple convertible notes with different terms and objectives regarding the company valuation. The best thing to pursue is to negotiate terms that will make the entire company a success and keep all investors aligned as possible. If an investor offers unique value, you can reward this with an advisory board role within the company or by offering of future deal flow.
Finally, we will end this list with a very obvious argument, but one that in reality is often underestimated: be as accurate as possible in managing your cap table. We still see a lot of cap tables passing through our office containing errors and/or missing information. The key thing to realize here is that a cap table it is not a fixed document and it requires a level of pro-activity to keep it up-to-date. Naturally, big changes occur when a funding round closes, but small events (vesting, option exercises, early-hires leaving, closing convertible loans, etc.) can add up as well. You can rely on a competent legal/financial counsel to maintain the cap table in a digestible format or use dedicated software such as Capshare.io or Carta for the more early-stage companies.
We hope this article will offer you support in building a clean cap table with a solid equity compensation plan to all shareholders. When it comes to the ownership structure of a company reconstructing past transactions can be costly and difficult to manage. As with a lot of things, it is better to prevent problems early on, than fixing it later. This particularly applies to a low-margin-of-error environment such as venture capital.