A startup’s cap table, or capitalisation table, is an important artifact for investors to evaluate a candidate for investment. In essence, a cap table shows who has put money into the company over time, on what terms, and who owns what. A cap table tells a financial story about the history of the company, and can be very revealing. It can tell a tale of woe, or sing a song of smooth sailing. For many startups, “it is what it is”.
Most early stage investors prefer a “clean” cap table, where the founders haven’t given away too much too soon, have retained a lion’s share of control, have steadily built value over time, have attracted a small number of smart, respected, aligned deep-pocket investors all wrapped up in a tidy package. As we all know, life doesn’t always work like that.
To better understand the stories of messy cap tables and how they got to be that way, I developed a taxonomy of messy cap tables: Fun, Spun, Under the gun, and Done.
The founders may have started their venture for a bit of fun as a side project, at a Startup Weekend, or an early accelerator programme. They might have been strangers at inception, or they may have been lifelong friends or former workmates. They likely decided early on to split the initial capital equally at the start, believing that they were all in this together, and would share the rewards equally.
Building a successful company took a lot longer, was much harder, and cost way more than the original founders ever thought possible.
Problem is, building a successful company took a lot longer, was much harder, and cost way more than the original founders ever thought possible. One of the original founders – the one who thought it was still fun – kept the passion and made their venture their life’s work, but another might have decided to start a family, another might have taken an amazing job with a ridonculous salary, and yet another had a falling-out with the original three, clinging onto their original idea which was invalidated by exposure to the real world actual market.
Now the Founder CEO, the one person doing all of the work, has a minor holding, and the other three sit on the share register and cap table as deadweight shareholders. They might have an interest in the success of the company, but they’re not aligned on where it should go. At best, they’re friendly and keen to help, but don’t have the capacity to do many of the hard yards required to achieve success. Most of the time, they’re relatively disinterested. And at worst, they carry a grudge that they didn’t get their way. All of them will believe that they contributed equally to the original idea, which they use to justify their relatively large but deadweight shareholding. Unfortunately for everyone, ideas are cheap, it’s the execution that counts.
Investors would prefer to see the potential rewards commensurate with the effort, risk, and most importantly the future work required to make the company successful.
Do you remember Spun, the 2002 movie about a 72 hour meth binge? That’s not what I’m talking about here, although I have met some founder teams that reminded me of the characters in that genre-defining film.
Here, “spun” refers to a company that has been spun out from a larger company, perhaps a joint venture, or a university or Crown Research Institute (CRI). The problem here is that the “founders” – or people doing the real work – don’t have a significant, or in some cases any shareholding in the company – if it’s hugely successful, nearly all of the benefits will flow back to the parent company. That’s pretty messed up. All the parent company did was put in a bunch of money, corporate salaries for the initial employees, intellectual property, support services, office space, beers on Fridays, lots of mostly irrelevant advice, and so on. Through the passage of time, as the spinoff discovers and pivots into its real market and iterates the product to match it, the interests of the parent and the venture diverge and these additional things that aren’t sweat quickly depreciate in value to nothing. History becomes irrelevant and in many cases turns into harmful baggage.
That corporate whale on your cap table is there until a liquidity event or a showdown.
While those Friday night beers were great fun for a few hours, and the cool kids in the spinoff bask in glory while their former coworkers have to get on with their boring jobs, that corporate whale on your cap table is there until a liquidity event or a showdown.
Under the Gun
A surprising number of founders don’t fit the stereotype of two white dudes from Stanford with rich parents. Bad luck for them. Maybe they don’t have the cash resources to take a year off out of the workforce to build their startup. Maybe their main jobs won’t allow them to do a startup side-hustle. Maybe they come from a disadvantaged background. Maybe they’re just inexperienced or naive. They need money to start their venture, but don’t have any. They’re under the gun – but totally passionate about bringing their startup to the world. They manage to convince their Uncle Herbert the Dentist or some unscrupulous “Angel” investor to give them $25K for half the company, which will keep them in two minute noodles for the six months they figure it will take to become a unicorn.
By the end of the process our founders will have three fifths of five eighths of bugger all ownership the company
Now Uncle Herbert the Dentist is on the cap table with half the company, and no interest or real capacity to contribute to its success. The company will need to raise a pre-seed round, then a seed round, and a Series A, and even if they’re lucky enough to find investors who will put money into a company where the founders have so little equity, by the end of the process our founders will have three fifths of five eighths of bugger all ownership the company. Will they want to work 100 hour weeks to make Uncle Herbert and the other investors a little bit richer? Probably not.
The company raised a pre-seed round. They didn’t quite make their milestones – but came close. So they raised another pre-seed round. They still didn’t make their milestones, but used their learnings to pivot into an adjacent and much more promising market with a new product. But they needed more money to do that, so they raised another round. The founders were very smart and lovable, and had the full backing of their core investor team. So when they ran out of runway, they asked their existing investors for some more cash, but this was a “down round” so the founders were diluted even more. And so on. At the next raise, the investors lost patience, appointed the mean guy to the board, and started looking for a fire-sale acquisition. Everyone was done.
These are some of the ways a cap table can get into a messy state, and I’ve seen them all at close range. There are some general principles that can help avoid these situations:
1. Use SAFE or convertible notes in really early rounds. Let’s face it, investors – you’re taking a gamble at this stage, and the founders need to retain enough equity to do a couple of meaningful raises later on.
2. Angels, don’t be predatory. Don’t take too much equity too early. Just because you can extract usurious terms from founders doesn’t mean that you should. You’ll be happier and better off in the long term if you pass on investments that don’t add up rather than extracting unfair terms that will cause grief later.
3. Founders, sometimes the terms on offer just aren’t worth it. Say no. Try to figure out quick paths to revenue, the best non-diluting investment you’ll ever receive. Keep searching for the right investors for your situation – and remember that it’s unlikely to ever be Uncle Herbert, unless you’re doing a dentistry startup. And even then.
4. Founder vesting agreements are a great way to ensure that the people who are actually working in the business are the ones who get the most meaningful stake.
Is a messy cap table a showstopper for investors? For some, yes. There are some well-known local institutional investors who say they won’t put money into startups where the founders have less than 80% at Series A.
If you look at the Fun – Spun – Under the Gun – Done filters, who’s left? The two guys from Stanford. And a few others that managed to scrape together the resources or revenue early enough to avoid doing dilutive raises, either by executing their early growth organically or finding investors who understand the long game.
The real questions we investors should be asking are:
1. Do the founders have what it takes to make the company a success?
2. Will they continue to be motivated throughout their tenure in the company, by ownership or something else?
3. Will the venture add to our collective goals as a society, and our individual goals as investors?
4. What can I contribute to the venture and its mission?
5. Does the venture have the ability to produce a good return on investment?
There is no cap table problem so big that it can’t be solved.
Finally, there is no cap table problem so big that it can’t be solved. There are a number of tools to do this, including a big ESOP issue, phantom stock, or just rewriting the cap table. These can be painful though, and it’s best to get things right the first time rather than fixing it later, as there can be really ugly tax implications to applying these tools. Often it takes some really tough negotiation with the ultimate threat of mutually assured destruction to bring about cap table changes necessary to put the company back on a strong footing. The general script for these conversations goes something like: “We’re terribly sorry, but things didn’t turn out the way everyone wanted them to. You’re going to be diluted by 90%. If you don’t agree, the alternative is liquidating the company, in which case everyone will get nothing. Please sign the agreements attached to this email.”
A messy cap table will not necessarily stop a company from being successful, or even being investable. The key thing that will attract investors to a startup is demonstrated market demand as measured by growth and ideally revenue. Given enough growth and revenue, most investors will roll up their sleeves with you and figure out how to overcome nearly any other problem.
I highly recommend developing a Capital Strategy before raising any money, where you plan out your raises and ownership levels for your venture. Use the template provided by Kindrik, the Loon Creek model provided by the ACA, or any of several cap table simulators available on the net. While (with apologies to von Moltke the Elder) no capital strategy survives first contact with investors, planning out your raises in advance will help you develop realistic expectations.
We’re entering a new period in the angel investment space in New Zealand, where we’re maturing as a sector and once scarce capital is becoming more available. Now is the right time to level up our practices as investors to put our ventures and their cap tables on a much stronger footing for future success. Helping our founders avoid early cap table problems is a small but important contribution we can all make.
Helping our founders avoid early cap table problems is a small but important contribution we can all make.