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broken cap table and how a startup can fix it
12 November 2020·8 min read

Ales Duchac

Credo Ventures

What is a broken cap table and how a startup can fix it?

Capitalisation table – a cap table, in short – stands for a list of a company’s shareholders including their respective ownership percentages. When an early-stage investor, typically a venture capitalist (“VC”), is considering an investment in a start-up, a brief look at that company’s cap table can reveal whether there is a healthy distribution of equity or not. Sometimes, shareholders’ ownership composition happens to be so alarming that it can either prevent an investment in what otherwise would have been a perfectly viable start-up or requires a frequently painful restructuring. In these situations, VCs typically speak of “broken” cap tables.

This article focuses on what a broken cap table means, in more detail, what are the possible
ways of fixing it and how both founders & investors should think about equity distribution from the very start of company formation to prevent a broken cap table in the first place.

Common denominator of broken cap tables – misalignment of shareholders’ interests

So, what does a broken cap table actually refer to? Typically, it means that shareholding of those who bring the most value to a company is disproportionately smaller to those who do not. If there is one shared cause for when any cap table starts to deteriorate, it is when one or more shareholders start pursuing goals other than the ultimate good of a company, which also includes reverse situations when shareholders do nothing. Issues can naturally arise on both founders’ and investors’ side and also at different stages of a company’s life cycle. We will try to describe the most common problems that we, at Credo Ventures, have been observing over the years.

Demotivated (or insufficiently incentivized) founders

First, an inexperienced founder might give up too much equity too soon – be it to angel investors or via several “seed” rounds. This can happen willingly through priced equity rounds or unwillingly through a number of convertible loans, not realising how much equity is actually being indirectly given out. Later on, when there is a need for additional capital, new external investors might be reluctant to provide it when they see how little equity – or in other words financial incentive – the founders (would) have left in the company. How much is too little? That, of course, depends on an individual, but founders should definitely have a majority in their company after a seed round, ideally after the Series A as well. Why is that important? Firstly, voting powers. Secondly, when the bad times come – and in start-up life-cycle they eventually do – founders can be more likely to abandon a seemingly unsuccessful project and take up more stable, quite possibly even better remunerated jobs in the corporate world. It is fair to add that financial gain is frequently not the primary or sole motivation for founders to embark on a start-up journey, which means that leadership can function perfectly well despite having smaller than usual equity stakes. Nonetheless, keeping the founders’ shareholding high is still one of the most effective elements for achieving their long-term perseverance.

Passive or completely inactive shareholders – equity holders should contribute

In relation to the above, the second source of potential problems are advisors, angel investors or sometimes even founders who might have provided certain value to a start-up early on but do not form an integral part of its management team anymore. In these situations, investors speak of “dead equity”. Passivity can also be a function of divided attention – frequently advisors & angel investors (and at times also founders) are involved in several start-ups and it is only natural when they shift their attention to where they perceive the highest chance of success at any given moment. Hence, they should think twice before offering equity and try to establish whether the given party will have a long-lasting impact for the project or not.

For the reasons above, prior to committing to an investment, institutional investors generally try to understand founders’ motivations and their level of engagement. If founders only have  one project running, there is no danger of diverting  their attention elsewhere.

Beware of greedy investors – when less can actually be more

Finally, if not chosen wisely, investors can also cause trouble, typically by being greedy and acquiring too much equity (in the 30%-40% range) early on (think seed stage). Why is that too much? Because there will be more investors coming in later and they will want to satisfy their equity expectations as well. The company will generally also need to create an equity stock option plan (“ESOP”) to motivate its key employees & C-level hires down the road. Taking all this into consideration, there wouldn’t be too much equity left for the founders. Fortunately, most investors realize that 10% to 20% equity stakes are sufficient for their purposes – it is useful to explain here how VCs think about equity. We will illustrate that with an example. For a $50M VC fund to be successful, it will seek cumulative returns of at least $150M (3x the fund’s size) given a standard 10-year fund term. Let’s say the fund will make around 20-30 investments. Assuming 10% of those bets will turn out well, monetarily speaking, it means 2-3 start-ups will be responsible for generating a vast majority of the fund’s returns. If the fund would have a 20% stake in 2 such companies, each of these would need to return $75M to achieve the fund’s return goal. That means for each of them to reach an exit valuation of $375M, which is not unrealistic. If a fund finds 3 such companies and achieves a 15% stake in each of them, then it would seek an average exit valuation of $333M (for each of these 3) to get to its cumulative returns target of $150M. As you can see, investors thus do not require 30% to 40% equity stakes to achieve their goals – 10% to 20% of stakes should generally be sufficient while also not making companies’ cap tables too crowded.

What can be done to fix existing issues? Founder ESOPs and buyouts

Despite your best efforts, if you still find yourself in a situation where you have given out too much equity and potential investors are giving you a hard time about it, creating an ESOP dedicated solely to founders can help alleviate the issue. Of course, this newly created ESOP will cause the existing shareholders to be diluted, but everyone should realize that a new (and probably much needed) investment in the company will increase its future prospects and so, in turn, also everyone’s potential financial gain stemming from an exit. 

If you realize you have given out too much equity to passive angel investors or various advisers that no longer bring any value to your company, a partial or full buyout might solve the problem. Obviously, there will have to be a negotiation concerning the buyout valuation, where it can indeed be very difficult to reach a consensus. However, who said fixing such a problem was easy? From experience, it is common that these buyouts are realized at a discount from the last round’s / currently perceived valuation. Also, buying out some equity from inactive shareholders can serve as a good opportunity for both existing and new investors to increase their shareholding in a start-up, especially if they were not able to acquire enough initially (or via primary transaction in the case of new investors).

How to avoid broken cap tables? Prevention is your best friend: educate yourself, think ahead & pick carefully

Having read the above, you probably realize it would be much better if you could avoid having to fix your cap table in the first place. You’re wondering what can be done to avoid all the pitfalls. Bad news first - sometimes very little, as your start-up’s situation could force you to do certain steps that you know are suboptimal, but at least it is good to be able to identify those situations. Thus, first and foremost, educate yourself to learn how much equity you should be giving out in an investment round on average (in our experience, 10-20% in Seed and Series A stages) and anticipate the effects of dilution down the road. If you decide to take on VC money and your start-up proves to be successful, there is a high likelihood it will need several rounds of funding. Pick investors wisely – make sure you agree on what a successful exit scenario looks like, what the given VC’s investment horizon is and what ownership stake they are targeting. Last but not least, ask around – get references from founders of that given VC’s portfolio companies – either inquire directly (the majority of VCs display their investments online) by reaching out on social media or ask your selected VC firm to provide contact information.

Good luck in your ventures and keep your cap tables neat & tidy!

Related Posts:

VC Tips For Successful Startup Fundraising (by Magdalena Balcerzak, Manager, Vestbee)

How Is Coronavirus Affecting Startups And Their Valuations? (by Magdalena Balcerzak, Manager, Vestbee)

How To Write Elevator Pitch For Investors (by Ewa Chronowska, Partner, Next Road Ventures)

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