While it’s very common to hear startup, CEOs raving about their feature sets, teams and publicity, few get excited about the internal workings of their startup’s finances. However, the way a startup is funded is just as much a source of competitive advantage, or conversely leadership weakness, as any of the other major areas of its business.
A bad cap table can be a serious headache for a startup. For one, it signals lack of discipline and possible future trouble. It also means that the founder or founders might not be motivated enough to slog it out in year 4 or 6 of a startup’s journey. Most startups don’t sell for billions or hundreds of millions of dollars. If they are sold, then it’s usually for $30 million and a founder with a very small (in the low single digits) equity stake in year 8, who has been taking a below-market salary for the better part of a decade.
On the other hand, a clean cap table presented during due diligence can inspire investor confidence in the founders and can help the startup close its round that much quicker. A strong cap table provides the right mix of good investors with industry-standard terms, it signals a high-level of competency among founders and exudes a certain aura of professionalism about the company.
So, what are some of the things to avoid for when organizing your capitalization table?
a) Too many investors
New potential investors are usually very wary of a cap table filled with lots of small, often first-time investors. This often signals a relatively low level of social proof in the industry, something new investors are always looking at. It may also mean difficulties in the future, as dealing with say 20 investors who all made contributions of $10,000 - 20,000 is usually more troublesome than working with 3 larger and more experienced angel investors. Many top-tier investors will not join a round if it has too many small investors or if those are already on the cap table.
b) A single investor
On the other hand, a single investor, especially if she or he has a close personal relationship to the founder, is another red flag. Startups want social proof, so having your dad as the sole investor in your company isn’t going to make your future fundraising rounds any easier. What you want is 5-7 investors, most whom have invested in startups in the past. There is nothing wrong in inviting family and friends into the round, but there should be other people who participate as well.
c) New investors facing negative returns
There are many things investors consider to be deal-breakers, including the fact that some investors will come in at such as small stake and at such a high valuation that it might be next to impossible for them to have a chance for a standard 10x - 30x return. Make sure that you crunch the numbers carefully and that any new investor has a realistic chance of making the standard return on investing in your startup. If that’s not possible then you will be endlessly struggling for high-quality backers.
d) The New Investor’s Position
Most new investors want to be paid back before all of the other investors. Their position in the liquidity range is often the centerpiece of the discussion. On the other hand, if the new investors are too privileged in relation to the earlier investors this will pose serious trouble in the event of a down-round.
e) Little or no employee shares or options
At the end of the day the motivations of startup employees are very different from those who work in the corporate or enterprise environment. Startup employees usually make much less in salary and direct benefits than their corporate peers and therefore seek motivation in other areas of their work lives. Accelerated learning and often much more responsibility is certainly one area and a potential hefty payday when the company sells is another. Startups need to have robust employee option pools available and lack thereof will be a deal breaker for some investors.
f) Playing favorites
This is a double-edged sword. Sometimes playing favorites - or something called high-resolutions fundraising - wherein the earliest investors get the most favorable terms in a round and those that join later get somewhat less favorable terms - makes sense for a startup. Other investors will balk at too many warrants and privileged shares, believing that it makes a startup’s situation messy and unclear.
g) Dead equity
Dead equity can be defined as any line-time equity holding by a former founder or key employee above say 2%, where that equity was granted (as opposed to bought) and that person is no longer involved in the startup. Dead equity can most often be avoided with a proper vesting agreement and buy-back provisions, allowing the company to purchase vested shares from a person no longer involved in the business. Most investors don’t believe that anyone should get a free ride.
h) The team being heavily diluted at the seed-stage
This is especially true in the case of startups coming to the U.S. from abroad, but holds true for plenty of companies right here in the U.S. On the other hand, it’s also important to make sure that founders are on a standard vesting schedule and that they are incentivized to not walk away from the company when the going gets tough.
Getting your cap table right requires foresight, planning and discipline. So, what does a good early-stage cap table look like?
A small pool of experienced angel investors, preferable some who have worked together before and have strong relationships with venture capital funds
A good-sized pool of employee equity that aligns the interests of those doing the heavy lifting with those investing
A standard vesting schedule that will incentivize founders to be in the business for the long haul
Common shares with possibly one class of preferred shares (without special warrants or multiple classes).
Growing a startup is hard enough, you really don’t need to stack the deck against you. A logical and clear capitalization table will make it easier for investors to pull the trigger and get you the funding you need to grow. Fortunately, our Pro Forma Cap Table app provides you with a clean projected cap table that will showcase your founders starting equity, seed financiers, option pool and series A and B investors. From there it will clearly outline your pre-money and post-money valuation and price per share.