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Common Causes of a Messy Cap Table

messy cap table

The puzzled look on a first-time founder’s face after hearing an investor’s concern of a “messy cap table” happens more than some probably think.  But what the heck does “messy” actually mean, and is later clean-up possible?  Answering those questions is the purpose of this article.

Evolution of a Cap Table in the Early Days

A capitalization table (aka “cap table”) is simply a ledger that records information about all equity holders of a company.  In the early day, it is really simple and probably just lists the founders and possibly some early advisors or startup accelerator program.  But with hiring and fundraising, the cap table quickly evolves.

The cap table doesn’t just grow in length (rows of entries) but also width.  That results from one or more funding rounds in which a Preferred class of equity is sold to investors.  Since those shareholders have different rights than the original Common shareholders, it is helpful to group them together by reflecting their information (share quantities and associated equity percentages) in unique columns.

Some cap tables end up reflecting alternate forms of equity grants such as warrants and convertible securities (convertible notes and SAFEs) that are intended to convert to equity in the future.

For a more detailed explanation and example of an evolving cap table, watch my video titled “Demystifying Cap Tables”, either by clicking the preceding link or watching it directly below.

What Does “Messy” Mean?

In a nutshell, a messy cap table is one that contains something concerning to the investor. It doesn’t simply mean the numbers don’t add correctly or the ledger is formatted poorly.

Messy cap tables have issues that create complications, risks, unfairness, or possible inefficiencies that could arise in the future.  Investors are already acutely aware of how risky most startups are in the early stages.  Seeing a startup with a messy, versus “clean” cap table just layers on additional risk.  How much additional risk varies based on the issues involved, which we will cover shortly.

Many early-stage institutional investors will immediately stop their assessment if they detect an overly messy cap table.  It is true that they could insist that certain matters be cleaned up (if possible) in conjunction with, or immediately after, the funding round is closed.  But after you learn more about what’s involved to clean up certain matters, you’ll better understand why the investor might require that you complete any cleanup before they will re-engage and continue their investment assessment.

Since serious angel investors, angel networks, and seed stage venture funds are typically the first professional investors to engage a startup, they are also the most likely ones to discover your cap table issues and, thereby make the resulting “messy” claim.  In some cases, it is the actions taken during the seed funding stages that create the issues, which means it will be the Series A lead VCs that discover the issues.

Now let’s investigate the most common causes of a messy cap table and possible remedies for each.

Too Many Ledger Entries

Whether your cap table is represented by a spreadsheet or an online service, it can easily accumulate lots of rows of information.  But why does this constitute a messy cap table?  The answer lies with the voting rights that equity holders have.  Several important business-related matters are approved by shareholders voting their shares, either for or against a given matter.

Going thru a voting process with a few founders is one thing.  Having a list of 28 angel investors on the cap table is another.  Chasing down approvals via repeated emails and text messages is a pain in the ass, and can result in impactful delays.

The process is further complicated when a Preferred class of stock is created for investors.  They get to vote separately on the most important decisions, referred to as Protective Provisions.  Once the 28 angel investors convert to Preferred equity holders, you might need a bunch of them to vote in favor in order to carry a majority vote.  Even then, your attorney will want you to push as far above 51% as possible to reduce the risk of a lawsuit that isn’t super easy to defend.

Having 10 angel investors on the cap table going into an institutional seed round with participating VC’s isn’t a problem.  Having 20 isn’t desirable, but probably won’t be a disqualifier.  Having 30 is likely to cause concerns.

The reason a rapidly growing team of employees with equity via stock options isn’t a concern is multi-fold.  First, it is expected, especially with success.  Second, employee stock options aren’t voteable until they are exercised and many employees don’t exercise their options until there’s an exit.  Third, the founders and top executives usually hold so much of the Common class equity collectively that just their votes will carry a large majority of the Common shareholder vote.

Typical Causes

    1. Raising very small amounts of funding (less than about $10K) from a bunch of friends and family
    2. Allowing small investment amounts (less than $25K) from angel investors
    3. Too many equity-compensated advisors (5+)

Possible After-the-Fact Remedies

There is very little that can be done after the fact to solve this problem.  It might be possible to restructure your friends & family investments to a traditional form of debt, so they won’t be on the cap table with voting rights.  And if you were aware of the issue early on, you could have attempted to push your friends and family into a single legal entity like an LLC or limited partnership.  Some startups raise their small seed round using an equity crowdfunding portal that rolls the investors together into a single legal entity.  With that, they might let $25K angels invest directly while pushing smaller angel investments to the crowdfunding portal.

Low Founder or CEO Equity

Investors need the founders to be excessively motivated to build a great company over time.  In the early days, that means oversized equity amounts to offset the excessively low salaries, and to provide a possible huge earnings windfall in the future.

If the founders will collectively end up with less than about 60% equity after closing their institutional seed round, investors will worry about possible low motivation.  For a Series A, the threshold is around 45% and might include the equity held by a very important executive that doesn’t happen to be a founder.

Although I’ve forced myself to give some guidelines, they actually aren’t that easy to define.  That’s because one scenario might involve four founders, each ending with 15% equity while another might involve a single badass ninja founder ending with 40% and accompanied by two others at 15% each.  But the concept is the same.  The investors pretty quickly decide which founders or very early execs are critical to building a great company and they want them to be motivated by holding sufficient equity after the funding round closes.  That probably means that not all founders will be evaluated equally.

Remember that in the case of the first institutional seed round, there are likely one or two rounds of convertible securities on the books that will also convert to equity as the round closes.  It means a double or triple whammy of dilution could be experienced at the same time. That’s why I didn’t mention equity threshold examples before the seed round closes, but rather after.

Typical Causes

    1. Raising too many rounds of funding before the institutional seed round
    2. Raising pre-seed and/or small seed rounds using convertible securities with excessively low valuation caps, causing those investors to get oversized equity amounts
    3. Giving up excessive equity to one or more startup accelerators
    4. Giving too much equity to employees, managers, executives or advisors
    5. Granting anti-dilution rights to early investors, advisors or startup accelerators

Possible After-the-Fact Remedies

The most common remedy involves over-sizing the stock option pool true-up that is typical with each equity round of funding and using a portion of it to true-up the equity holdings for the most critical founders or execs.  But this means even extra dilution to all other prior holders of equity, possibly including the earlier investors that held convertible securities.  You might have a fight on your hands.

Excessively low valuation caps from your first round(s) of funding and anti-dilution rights might be able to be renegotiated, but not without effort and stress.

Fully-Vested Founders

If a founder is fully-vested in their equity, they can leave the company and take all of their equity with them.  Hopefully, after becoming fully vested they’re still super passionate about the company’s vision and potential.  But if they’re still an important contributor to the company’s progress, investors will want to ensure they aren’t an easy flight risk.

Typical Causes

    1. Long period of time between founding the company and the first round of funding from professional investors.
      • If you’re still in the early, early stages, consider resetting the vesting schedule for founders and early employees to a 5-6 years.
    2. Founders receive outright grants of equity with no vesting schedule included
      • If you’re still in the early, early stages, consider amending the equity grants with a vesting schedule

Possible After-the-Fact Remedies

The most common remedy involves the investors insisting on resetting the vesting of founder equity.  Oftentimes, this involves allowing something like 25% of the equity to remain vested but subjecting the other 75% to a new 4-year vesting schedule.

Dead Weight

The concept of “dead weight” simply refers to a founder or employee that got a meaningful chunk of equity but is no longer with the company.  If that founder/employee was subjected to a 6-year vesting schedule and the amount of equity they were granted was reasonable, there’s probably not a big issue to resolve.  Same with an advisor that got a reasonable amount of equity for a 1-2 year gig that is no longer active.

Common Causes

    1. Excessive equity granted to a founder or employee, as compared to their role or contribution
    2. A 4-year vesting schedule causes full vesting before the company is ready to raise a real round of funding, and one or more of the earliest employees have already departed

Possible After-the-Fact Remedies

If the amounts of dead weight equity seem unfair to the investors, they might ask that the company take actions to specifically dilute the holders of dead weight equity.  This can be done either before or after the funding round, and usually involves authorizing and granting additional equity to every shareholder except for the ones targeted for dilution.  You must have your experienced corporate attorney involved in this action to make sure it’s done by the book.

Investors Holding Common Stock

In the early days, startups might come across investors that don’t want to use a convertible security to reflect their investment.  Instead, they insist on equity.  Rather than create a new Preferred class of stock for those investors, with special rights, the startup might decide to just sell them Common class equity.

The problem with this is two-fold.  First, it has the unintended consequence of increasing the fair market value of the Common stock to reflect the fundraising valuation of the company, rather than a price that is much, much lower.  That, in turn, increases the exercise price for all future stock options, which makes them a less attractive compensation tool.

For more on this slightly-complicated topic of stock pricing, read my article titled “Pricing Your Stock in the Early Days

The second problem is that later, when there is a Preferred class of stock held by investors, the early investors will be voting as Common shareholders.  That creates a misalignment and can actually mess up voting power on the Common class side of the cap table.

Common Causes

This issue results from selling Common stock to investors rather than using a convertible security or selling them Preferred stock.

Possible After-the-Fact Remedies

It might be possible to exchange the investors’ Common stock for the newly-created Preferred stock, once it is created.  It might also be possible convert them to a different class of Common stock that votes separately.  In other words, Common A for employees and Common B for investors.  This is a complicated matter that should involve you experienced corporate attorney.

Summary

As you can see, there are numerous possible causes of a messy cap table.  And I’m sure I’ve missed some.  You hopefully also noticed how difficult, or sometimes impossible, it can be to remedy a situation after it is discovered by professional investor due diligence.  Engaging an experienced corporate attorney in the early days, especially one that understands incorporations and early-stage startup matters, is the best remedy for avoiding all of these issues.

This is just one version of what I refer to as accumulating “by-the-book” debt.  If you would like to learn about the other common issues of by-the-book debt, read my article titled “Accumulated By-the-Book Debt Eventually Comes Due“.

 

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