The capitalization table, or “cap table” in short, outlines the ownership of equity within a startup. While cap tables might look unassuming at first, they do have very profound implications for a startup’s potential. It is essential for aligning the company's trajectory towards growth by motivating executives and enabling decision-making processes.
Early decisions in a startup’s life can cast a long shadow over the cap table. Companies with a promising tech, a skilled team, and ambitious goals, can yet have a capital structure that is misaligned with their future success. These situations can be detrimental to all stakeholders: existing investors might find themselves with undervalued shares, the management team could experience dissatisfaction and high turnover, and prospective investors may be deterred or demand unfavorable terms or recapitalization. Ultimately, such misalignment throttles the company’s potential.
Here are a couple of common cap table pitfalls and how to fix them.
Equity with the wrong shareholders or “Dead Equity”
Given that startups often lack the revenue to provide substantial salaries and bonuses to key executives, ownership becomes a vital motivational tool. The theory is straightforward: start with 100% ownership and gradually dilute by share issuances to new shareholders as the company grows. However, things become complicated when early deals leave too much of the company’s equity in the hands of passive shareholders, creating what is often called “dead equity”.
There are several categories of “dead equity” that can be frequently encountered:
- Dormant Founders: Many startups have founders on their cap table who played a significant role in the early days but may not be actively involved in the future. They might have left the company or transitioned into a different, more passive role.
- Accelerators/Incubators/Venture Builders: These programs often contribute significantly to a startup’s early development and success. However, their impact diminishes as new investors take on a more influential role.
- Business Angels: Angels are typically the initial source of funding for startups. While their support kickstarts the company, their role in shaping its future success is limited.
It is possible for these four categories of shareholders to collectively own a significant proportion of the company before any institutional money comes into the picture. It is important to reward them fairly for their contributions in the early stages of the company, while ensuring that those who will create future value receive their fair share. The split between past contributions and future value should be heavily weighted towards the latter, even if this goes against human nature. Here are some practical guidelines:
- Dormant founders should not own a significant portion of the company. Implement a vesting mechanism even before the first round of equity financing to have a default mechanism in case a co-founder leaves the company early.
- Limit accelerator involvement and avoid having too many of them on your cap table. Venture studios that are actively involved in the creation of a startup may hold a little more. However, the management team should ultimately take over and create future value. While early idea generation and development is an important contribution, execution will be a critical success factor and should be underpinned with sufficient equity.
- Angels, typically entering at the pre-seed stage, should not own more than 15%.
These measures help ensure that the executive team maintains a substantial stake in the company, fostering their continued motivation and commitment.
A fragmented cap table or “Deadlock”
In any company, including startups, shareholders will have a say in certain decisions. For some of such decisions, the business will require swift resolutions.
In an ideal cap table, the majority of equity is owned by the individuals actively propelling the company forward – the executive team and current active investors. This configuration streamlines the decision-making process, facilitating quick responses and the execution of crucial strategic decisions.
- Fragmented Cap Table: If a company has accumulated small investments from many angels or small funds without a clear lead investor with a significant stake, it becomes difficult to achieve the consensus needed to make decisions. If angels come from a variety of sources and backgrounds, they may not be used to quick decision-making or local legal requirements.
- Veto Rights: Even minority equity stakes can wield considerable influence if shareholders have been granted special rights, like veto power over major decisions. These rights can hinder decision-making processes and discourage new investors who want to avoid the complexities associated with navigating around such rights.
The solution for maintaining a clean cap table conducive to decision-making is as follows:
- Where possible, pool the voting rights of smaller investors to simplify the voting process. Voting pools or pooling entities can work wonders here. Instead of having to rely on and organise a large number of different angels, all the power is concentrated in one or two reliable individuals. If there is a conflict of interest, the Angels can still vote separately. But this approach avoids the chaos of herding cats.
- Avoid granting veto rights or excessive voting powers unless there are exceptional reasons for doing so. Read the fine print, calculate the number of shares and determine the majorities required for decisions. Often, investors inadvertently acquire de facto veto power because someone failed to do the math. Attention to detail is key.
Fixing a Broken Cap Table
Despite best efforts to avoid pitfalls, complex and messy cap table are not the end of the road. Cleaning up a messy cap table is a daunting task but far from impossible. It may involve challenging discussions and negotiations, but it is in everyone’s best interest to position the company for success.
Here is a roadmap through the process:
- Analyze current cap table structure. Understand who holds what, including any special rights attached to their equityholdings.
- Initiate a dialogue with relevant parties. For dormant shareholders, consider options like buybacks, secondaries, or equity dilution. Negotiating with accelerators, or angel investors may be necessary to rebalance the cap table in favor of the executive team and future investors.
- In some cases, a complete recapitalization may be required. This process can involve reissuing shares or creating a new class of shares to reset the cap table, aligning it with the company’s future success.
Engage legal and tax advisors in these discussions, as tax considerations often pose significant challenges to fixing a cap table.
A clean cap table is not merely an administrative detail; it is a strategic asset that can profoundly impact a startup’s future success. While cleaning up a messy cap table may be demanding, it is an investment in the company’s future that can yield substantial dividends in the long run.