Protect Ya Cap Table

I grew up in Brooklyn well before it was the cool place to live. If anything, it was the place you wanted to escape from during one of the bleakest times in the history of New York City.

Being raised in this environment made you tougher. You learned at an early age to always be aware of your surroundings and to be slow to trust others. If you did not protect yourself, you were liable to get taken advantage of or worse. On the upside though, the rawness of the streets were the ingredients of some of the best hip-hop ever penned, from Biggie to Jay-Z to Wu-Tang Clan.

I thought this worked to my advantage when I joined the workforce. It gave me the skills to negotiate, to probe, and to understand motivation. That is until I launched my startup, when all of those life lessons immediately disappeared.

When you do not have many resources, you get desperate and grab onto anything that could carry you through to the next day. We needed engineering help, so we gave away equity to an outsourced dev shop. We needed industry credibility, so we gave away equity to anyone that would join our board of advisors. We did not have enough income to pay salaries, so we gave even more equity away to various consultants and early employees in lieu of full cash compensation.

Not everyone would accept equity for services, so we also needed actual cash. Beyond what we put in ourselves however, we still did not have enough. So we hit the road to wrangle cash out of friends and family and others in our network for a small initial round of capital. For their generosity, we gave away big chunks of equity as a way to thank them for the insane risk they were taking.

We gave away equity like it was candy to anyone that chipped in. We figured it was free. Besides, it got us some much needed help and unlocked resources that we didn't have access to at the time because we were well short of the cash to pay for anything.

What we did not anticipate was the reaction from VC’s when we went out to fund raise. If we got far enough in the discussions, investors always asked to see the current cap table that listed all of our investors and their percentage equity holdings. Investors took one look at our cap table and said no thanks.

Our cap table was a complete disaster! There was no rhyme or reason as to how we allocated equity and at what valuation. A bunch of equity was effectively dead with non-participating advisors. We had not raised a proper institutional round, yet we were dangerously close to losing majority ownership of the startup.

I thought we were incredibly naïve and dumb. It turns out however that a lot of startup cap tables are even more chaotic and difficult to navigate. Even with the advent of cap table management tools, cap tables are becoming even harder to keep straight for founders, investors, and the lawyers involved.

How are founders getting into this mess? Here are the ten most common issues we often see:

1. Ad-hoc equity issuances – Issuing equity without a structured plan results in a fragmented cap table with multiple classes of stock and complex ownership.

2. Granting equity too liberally – Being too generous with equity can lead to a fragmented cap table with too many small stakeholders and lots of dead equity.

3. Using equity as compensation – Compensating advisors, contractors & employees with equity without clear expectations can muddy the cap table and create potential liabilities.

4. Misaligned vesting schedule – Lack of a proper vesting schedule for founders and early employees complicates equity distribution and leads to disengagement for those vested.

5. Failing to account for dilution – Not anticipating the dilutive effects of future funding rounds can lead to founder and early investor ownership being diluted more than expected.

6. Poorly managed option pools – Not implementing an Employee Stock Ownership Plan (ESOP) with enough shares for future hires can impact the ability to hire the best talent.

7. Improper record-keeping – Poor record-keeping practices, such as using multiple spreadsheets or failing to update the cap table regularly, can result in errors and inconsistencies.

8. Overcomplicating the structure – Overly complex equity structures (e.g., common & preferred stock, convertible notes, SAFE agreements) make the cap table difficult to manage.

9. Lack of legal guidance – Failing to involve experienced legal counsel, especially during funding rounds or significant equity transactions, can result in non-compliance and legal issues.

10. Misbalanced ownership – Too many small investors or one large investor causes management issues and slows decision making.

As you can see, there are numerous issues beyond attracting investors that a poorly managed cap table leads to. It affects the ability to hire, make fast decisions on significant corporate actions, and could have legal and tax ramifications.

The most critical issue though of a convoluted cap table is you limit your upside as the founder! The goal of a clean cap table is ultimately to align the interests of all stakeholders from founders to investors to employees towards building the future success of the company. To that end, you want the majority of equity owned by people driving the company forward, founders and active investors.

How can you ensure you maintain a cap table the reflects this future success and adequately aligns and incentivizes all stakeholders? Here are a few suggestions:

• Use software – Even if you only have a few stakeholders, cap table software will track equity ownership accurately and do the heavy lifting of managing all equity vehicles, especially SAFE and convertible notes.

• Actively document changes – Update the cap table regularly, especially after significant events like fundraising rounds, issuing new shares, or employee stock option exercises.

• Leverage your lawyers – Your legal team should review the cap table periodically to ensure compliance with regulations and that it accurately reflects the company's equity structure.

• Educate stakeholders – Communicate transparently with founders, investors & employees so they understand the implications of their equity holdings and changes in the cap table.

• Plan for dilution – Anticipate dilution that will occur with future funding rounds to properly set expectations for existing shareholders and inform decisions on new investments.

• Set proper vesting schedules – Implement clear vesting schedules for equity and employee stock options to prevent sudden changes in ownership percentages.

By following these practices, you will not only set up yourself and your startup for the best possible outcome, but you also better understand the trade-offs when investors come with term sheets. You also reduce the stress and blockers later down the line. It is much easier to establish good practices now than to fix mistakes and force a painful recapitalization when the stakes are higher.

What has been your experience managing startup cap tables? Did you run into any complicated issues because of your cap table?

Mark & Basil

All this talk about cap tables reminds us of a story from last summer on the topic of venture studios and their larger ownership stake. The venture studio model is built on incubating startups, so it makes sense that they should get a larger equity stake. But could it also make these startups uninvestable as they scale and require more capital as the article suggests?

Venture studios are not a new concept. Some of the most well-known ones like Idealab, Betaworks, and Rocket Internet have been incredibly successful with dozens of exits. Idealab had 35% of their startups exit via IPO or M&A, and 5% became unicorns, a staggering rate of success!

That level of success is the exception though. Of the several hundred venture studios scattered across the globe, most are still searching for at least one meaningful exit. The biggest challenge is often trying to get follow-on investors for later stages of funding.

The general rule of thumb is that VCs want to see the founding team own the majority of the equity into and past their Series A. The thinking is that this better incentivizes the team and encourages them to stick things out when the going gets tough. When VCs come across a startup incubated by a venture studio and their larger initial stake, VCs generally turn those startups away.

We believe venture studios can still be an excellent opportunity for experienced entrepreneurs despite the potential risks in downstream fund raising. There are plenty of talented operators that could lead a startup, but lack the idea or the means to get started, so a venture studio takes both risk and time off the table so the operator can dive in immediately to scale the business. The other situation that is worthwhile is in emerging startup ecosystems that do not have a mature early-stage funding market or support systems for entrepreneurs. Venture studios bring experience, expertise, connections, and capital in these regions to close the gaps and accelerate progress for these founders-for-hire.

Mark is looking forward to being in Southeast Asia for the next two weeks from March 19 to March 29. Here’s the schedule and look out for updates on Mark’s LinkedIn for events he will be at or hosting:

• Singapore: Wed, Mar 20

• Bangkok: Thu, Mar 21 - Fri, Mar 22

• Saigon: Mon, Mar 25 - Tue, Mar 26

• Singapore: Wed, Mar 27

• Kuala Lumpur: Thu, Mar 28 - Fri, Mar 29

Big thanks this week to the SOSV team for having us over for their HAX & IndieBio - Deep Tech NYC/NJ event this week. It was a great opportunity to meet with deep tech and biotech startups, showing that the NYC startup ecosystem is a lot more diverse in the range of startups building here.

We have been working on some content projects as well. Basil will be making the big reveal of his series very soon. In the meantime, Mark just uploaded a new series on YouTube called Founder Mistakes, based on a previous newsletter called “21 mistakes I made with my startup”. Check out the videos and tell us about some of your own lessons learned. If it is a good story, we can feature it in a future newsletter!