Cap Table Nightmares: Tales from the VC Crypt
It's towards the end of the pitch. The company has been convincing and the team is impressed. Now is the time when one of us will usually ask the question - hoping for the best, but ready for the worst: what does your cap table look like?
The answer to that question won't only affect our investment decision (and, should we decide to proceed, the investment terms), but may also have a significant impact on the ultimate fortunes of the founders, the investors and the company.
What are cap table nightmares, what causes them, why are they so terrifying, and most importantly, what can you do to avoid them?
Cap table nightmares can take many forms, but the most pernicious ones usually involve the shareholdings of the active founders of the company being disproportionately low for the stage of development of the company and significant stakes being held by uninvolved or unprofessional parties. Imagine, for instance, a situation where the active founders only hold around 35% of the company after having completed the company's first institutional round and other individuals hold double-digit stakes, and you can feel your heart skip a beat. Imagine further that the 35% held by the active founders is far from evenly distributed between them and that one of them - the CEO - only has a stake of 6%, and you're left gasping for breath.
The Cold Sweat: Cause and Effect
Part 1: Cause
So, what causes these nightmares?
The Ghost of Founder Ex
One of the most common causes of a cap table nightmare is where one or more of the original founders of the company has, at a very early stage, jumped ship taking their equity stake with them. This means that a large chunk of the value that will (hopefully) be generated by the company will be for the benefit not of the team whose blood, sweat and tears have built the company nor to the investors whose funds and strategic guidance have propelled the company forward, but to a silent, inactive third party whose contribution to the company might be limited to an idea (or part of an idea) and a few months' toil. And that is the best-case scenario because it is far preferable to the alternative: a meddling and obstructionist ex-founder with significant voting power.
It's Raining Convertibles
Another common cause is the use, or rather abuse, of convertible loans or SAFEs in pre-institutional rounds. While it might make perfect sense to get some early funding through a convertible, the danger, like with meth, is addiction. One convertible quickly turns to two which turns to five and, before you know it, you've taken $2m on terms that are, at least in part, TBD. There might be a cap, there will definitely be a discount and usually no floor and, of course, the pain doesn't hit until the institutional round comes around and it is (finally!) time to convert. Would the dilution have been less had the company completed priced rounds? Perhaps, perhaps not, but it would have been felt far earlier and, then, more keenly.
The Petrifying Pivot
Then we come to the pivot. The company is changing course and it's taking its existing investors with it! The company has had a checkered past, but boy do they seem to be on to a good idea now. Of course, we'll have to start all over again. This is a seed deal - but not as we know it because if the company has already gone through even one or two significant rounds of financing before starting again at a very low valuation, the cap table will be out of whack.
A Founder by any other name
What's in a name? Surprisingly, quite a lot when it comes to founder terminology. In some companies, the two or three "Founders" start with roughly equal stakes; in others, the founders' stakes vary widely with the original "Founder" holding by far the largest stake and one or more "Co-Founders" holding far smaller stakes (and if a new CEO or other C-Level team member is brought in prior to the A round, they may only be granted options and not be any kind of founder at all).
The set-up that is chosen usually represents the founders' understanding of the proposed allocation of responsibilities (and the importance of those responsibilities) on day-one and may also reflect the point in time at which each founder joined the venture. While conclusions based on those considerations may be valid, events can easily overtake them. Responsibilities can change even in the relatively short period of time before the first institutional round, and what seemed a sensible allocation of equity on day-one, may seem lopsided 6 months later. Of course, the exact founder terminology used doesn't matter much; it's the equity stake implicit in the name that is critical and the problem arises where those who are most critical to the future success of the company aren't being treated as founders economically.
Part 2: Effect
We believe that the founders of our successful companies should make more money than we do. Founders usually concur. But beyond the obvious point that smaller founder shareholdings will result in a smaller part of the eventual exit proceeds, there are other reasons why nightmare cap tables terrify.
Firstly, founders with small shareholdings will often find themselves in a perpetual state of negotiation with new and existing investors about the terms of their relution. This is a distraction from the important work that they need to undertake. It can also cause significant friction with existing investors who are expected to bear the dilution of the relution and, in a fundraising process, with new investors who will struggle to come to terms with the cap table and how to insulate themselves from excessive dilution in the future.
Secondly, they limit the ability of founders to transact for their own benefit as well as for the benefit of the company and its investors. Secondary sales are a nice way for founders of successful companies to take a bit of money off the table in return for value-creating stellar performance. As founder secondaries (being sales of the lowest ranking common shares) are usually completed at a discount to the round price, they can also be a useful tool to smooth the completion of a high-value financing round by offering incoming investors a lower blended price per share. However, investors will struggle to agree to secondaries when founder shareholdings are low and relution has already been an issue or is expected to become an issue in the near term.
Small founder shareholdings can easily serve to dealign founders' interests from those of the existing investors. After all, if your equity stake is small and you are counting on being reluted in the next round, there is less incentive for you to push for higher valuations or to limit the round size (and consequent dilution) to the amount reasonably needed. The likelihood of lower round-on-round valuation multiples and, ultimately, an inferior return for investors, increases.
If the active founders don't hold the shares, then who does? This matters greatly and if the shares are in the hands of someone who has fallen out of love with the company or whose priorities are different from those required of a venture-backed company, the cap table nightmare might be more than an economic one: it may lead to problems in governance. Not all legal systems are as flexible as, say, Delaware corporate law, and in many countries in Europe uncooperative shareholders have substantial power to disrupt and delay corporate action. They may withhold their proxy for shareholders meetings, insist upon long notice periods being observed and, in jurisdictions where privity of contract means that agreements cannot be amended without all parties' consent, withhold their signatures. This can become particularly troublesome in the context of a fundraising process that already has enough moving parts. The villain may be the obstructionist founder ex or a historical investor who either doesn't believe in the company's rapid growth strategy (and therefore disagrees with the company raising funds (again!) and increasing its ESOP pool (again!)) or who has fallen out with the founders over alleged historical misdeeds - perhaps those actions that lead to that petrifying pivot.
Sweet Dreams (are made of this)
So how can we make sure we can all get a good night's rest?
Put it into Reverse!
Whenever I discuss reverse vesting with founders about half of them already know why it is so important or readily grasp its importance. The other half smile politely knowing that we are just trying to steal their shares and that their job is to limit the number of shares we can steal and the period of time during which we can orchestrate the theft. However they feel about it, not that many founders put in place effective reverse vesting rules before they raise institutional funds and that is a real shame. Reverse vesting, if implemented forcefully and correctly from the outset, can banish the ghost of the ex-founder by ensuring that the founder exits with as little equity as possible. When devising reverse vesting provisions it is also worth considering the influence that the ex-founder may continue to wield even after leaving. If the founder is on the board, what will happen to their seat after they leave? If they leave mid-way through vesting and, therefore, retain substantial equity, what will happen to their voting rights?
The founders of one of our very early-stage companies recently came to us with a proposal: they wanted to promote their senior tech hire to founder status and transfer to him a portion of their founder stock. This shows tremendous foresight in anticipating and taking concrete steps to prevent a looming cap table nightmare. It may not be a solution for all companies, but if you are a very early stage company and the actual allocation of responsibilities shifts from that initially imagined, considering re-allocating founder equity either among the existing founders or to a new member of the founding team can certainly make a lot of sense.
Control your Convertibles
Give serious thought to the terms of the convertibles you take at an early stage. You might be thrilled that you are able to get some pre-seed capital, but that initial exuberance must be tempered by the hard-nosed business executive in you that looks at the long-term. And long-term you need to have a clear view of where the convertible is leading you. The number of very early convertibles I see that have ridiculously low caps and equally ridiculously high discounts would even make Mark Zuckerberg blush. Caps in convertibles generally (and not only in pre-seed/seed financings) should be a back-stop against incredible over-performance – that is, they should be set at such a high level that they will only kick in where the company has performed above your wildest expectations. They should NOT be equal (or close) to the valuation that an investor is willing to give the company today. Likewise, discounts should be accepted, of course, but be commensurate with the additional risk being taken and should be entered into on the basis that the convertible will be a short-term instrument to get the company to its first proper round and not as one of a series of convertibles rolling along towards the cliff-edge of a priced round.
Unless that is the plan, in which case you really need to think quite differently about the terms of your convertibles. To begin with, you need to acknowledge that you can't see many years into the future and that it would be sensible to put a floor into the equation so that you know the maximum dilution to which you are potentially exposed. Likewise, you need to revisit the "standard" term that convertibles convert into the same class of shares as those issued in the financing round in which they convert. For investors will often find it difficult to accept that a pre-seed investor who paid a fraction of the price per share many moons ago will have the exact same rights as the series A investors.
In the most extreme cases where the original business model of the company has failed and management has decided to pivot to a completely new business, a total recapitalization of the company may be the only viable option to give the company a second chance. Terms will generally include the issuance of a large number of shares at a low valuation, all but wiping out existing investors. This will usually be accompanied by the conversion of all existing preferred shares into ordinary shares, thereby eliminating historic liquidation preferences, anti-dilution protection provisions, and governance rights. Of course, you cannot wipe out existing investors without also wiping out founders and management and so this approach requires that a very large share option pool is put in place at the same time.