Ask an Investor: What is a broken cap table?

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Your customers love your product, and your company is growing like crazy. You’ve crafted a brilliant deck, practiced your pitch, and it’s all perfect. You’ve connected with VCs and built many relationships. You’ve even prepared ahead of time for everything, including due diligence. You are more than ready to fundraise. The first meetings with investors go well – their body language screams they are investing. You send over your data room and hear…nothing. No one is responding.

What the hell just happened?

You start calling around and finally get one of the investors to admit that the reason they aren’t moving forward is a problem with your cap table.

You’re dumbfounded. How could the ownership of the company be a problem!?

The best way out of a bad cap table situation is to never get into one in the first place.
 

It turns out that the ownership of the company, the capitalization table (often just called the cap table) is a big deal to investors, and there are any number of ways its makeup can be a deterrent to investors. It’s a deterrent to investment because a ‘broken’ ownership structure can do everything from disincentivize a founder from performing at his or her peak to making important strategic decisions extremely difficult to execute.

The typical challenges of managing with large numbers of investors (20+) are made even worse when a cap table is broken. Founders may find themselves spending a crushing amount of time chasing documents, signatures, and call-backs rather than focusing on the business. New investors aren’t interested in backing a founder and company who will have these issues.

Over the years, investors in the technology sector have clustered around a set of ‘ideal’ cap tables. The given ownership percentages aren’t written in stone, and you could easily change them (by plus or minus 10 percent), but the farther you get from this setup below, the harder it will be to claim your cap table is ‘normal’.

In the following table we show what investors typically look for in a cap table at various stages of financing. Don’t obsess too much on the exact percentages, every situation is different and, as I mentioned above, this isn’t an exact science.

* The employee amounts listed here would all be in an employee options pool. Initially, that option pool would unallocated (i.e. not given to anybody). As the company grows and hires more people you would allocate options from this pool. Furthermore, it’s become standard that options convert into non-voting common shares.

Cap tables are not static, they change far more often than most founders realize. Obviously, big changes occur when a funding round closes, but the little changes can add up as well. For example, a key early hire quitting before they are fully vested will have a profound impact on the options pool. That early hire, exercising their options, would, in turn, have another ripple effect to the cap table.

Investors are on the lookout for any and all cap table issues. Issues that could potentially create friction in future rounds, key partnerships, at exits or any other time shareholder consent is required.

Here are some of the most obvious ones:

• The biggest issue, by far, is too small of an ownership position by the founding team/founder. Post the seed round, if the founding team + ESOP is less than 50 percent, you are entering dangerous territory.
• If the CEO, post the seed round, owns less than 10%, you are in real danger territory.
• If you have ‘dead equity’ – this is loosely defined as equity in amounts greater than two percent that is owned by a former founder who is no longer actively involved with the company. We call this dead because it a) hasn’t been paid for and b) the owner isn’t actively involved in growing the business. Investors want that equity owned by the active founders. This goes along with advisors shares. Some small % is acceptable, but any equity that was granted (not purchased) to someone who isn’t actively involved in the day-to-day of the business becomes problematic to investors. Further, this also applies to investors where they have been granted shares on top of their paid for shares. New investors will always take umbrage at granted shares outside of founders/employees.
• Speaking of employees, if they don’t have any equity or very little, investors typically will have an issue with that. We know that employee options pool play a huge factor in attracting and retaining the best talent. If you shortchanged your employees, we know that this will cause trouble in the future of the company. We want nothing to do with it.
• You have any unusual securities on your cap table. Like three or more classes of common shares or shares that pay a fixed dividend (what the public markets folks would call a preferred share, just to confuse things!), warrants or other deal sweeteners.

All of the items on the list are unattractive and even deal-breakers for investors. They each cause investors to question if you and your team will be aligned with the success of the company and what other interests they will need to manage in the future.

Technically, these cap table issues can be fixed. It just requires the unanimous consent of all shareholders and some mechanisms to either convert and/or cancel the various offending securities.

Realistically, they almost never get fixed and the company folds. Current investors are almost universally resistant to any changes to the cap table without a new investor forcing the compromise. New investors, however, are unwilling to put forth a term sheet that involves fixing a cap table without prior unanimous shareholder approval to fix the cap table. It makes sense for new investors to hold off. It is not a sure thing that all of the current investors will accept any proposed changes. This is a classic impasse. In the venture capital business, where no fault is too small to pass, a broken cap table likely means no investment.

Finally, the best way out of a bad cap table situation is to never get into one in the first place.

Sarah’s take

Christian made a really important point that can be your high-level north star in examining your cap table – the distribution of equity should serve as an incentivizing force that aligns the founding team, early and/or outstanding employees, and your investors around success.

Dead equity is a point that needs to be hammered home. In a best-case scenario, you’ve either included founder vesting or drafted the founding documents to include a buyback provision (granting the company the right to purchase back some percentage of the granted stock, tied to the time spent at the company, at the original purchase price). These terms can feel unnecessarily cautious or onerous when you’re first founding the company – who wants to think of things going poorly and losing a key member of your team? But dead equity is a direct loss from either the remaining founder team or the ESOP, and this lost equity can create misalignment among employees via an insufficient reward for performance. Depending on your shareholders’ agreement, these equity holders can resurface and create problems during an acquisition offer.

I don’t agree with his comments around recaps. Like most taboo topics, I think they’re more common than you might assume based on polite conversation. They’re a hassle, but investors tend to think about “if this works, what does the company look like and how big can it be?” If you, your business and the market opportunity are compelling enough, a small mistake around angel investor terms or a fully-vested founder who has left the company won’t kill an investor’s interest.

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