When your cap schedule makes your startup uninvestable

CEO of Norwegian The hardware startup shared with me a presentation that contained an unusual slide: It included the company’s capitalization table—a breakdown of who owns what part of the company. Typically, cap tables are involved in the diligence stage of investing.

Taking a closer look at the table, there’s something dramatically wrong:

The problem here is that the company gave up more than two-thirds of its stock to raise $3.3 million. And with the company embarking on a $5 million fundraising round, that presents a serious hurdle.

TechCrunch spoke to a number of Silicon Valley investors and hypothesized whether they would invest in a founder who presented a cap schedule with similar dynamics to those described above. What we’ve learned is that the cap schedule as it stands today makes the company uninvestable, but there is still hope.

Why is this a big problem?

In less developed startup ecosystems, investors may tend to make short-sighted decisions, such as trying to acquire up to 30% of a company’s shares in a relatively small financing round. If you’re not familiar with how startups work in the long term, this might seem like a reasonable goal: Isn’t it the investor’s job to get as much back as possible for the money they invested? Perhaps, yes, but hidden in this dynamic is an actual poison pill that can limit the size a startup can reach. At some point, the company’s founders have so little equity left that the cost/benefit analysis of the grueling death march running the startup starts to turn against them and they continue to give it everything they have.

“This cap table has a giant red flag: The investor base owns twice as much as the three founders combined,” said Leslie Feinzig, general partner at the company. Graham Walker. “I want founders to have a lot of skin in the game. The best founders have very high earning potential – I want them to be undeniably worth their while to continue for many years after I invest in them… I want the incentives to be perfectly aligned from the start.”

Feinzaig said that this company, in its current state, is “essentially uninvestable,” unless a new potential client comes along and fixes the cap schedule. Of course, this in itself is a high-risk move that will take a lot of time, energy, money and lawyers.

“Setting a cap table means cornering existing investors and returning ownership to the founders,” Feinzaig said. “This is a bold move, and not a lot of new investors will be willing to go that far. If this is the next OpenAI, they have a fair chance of finding a potential customer who will help clean this up. But at the seed stage, it’s very difficult to stand out with that clarity.” , not to mention the current venture capital market.

With unmotivated founders, the company will likely exit sooner than it otherwise would have. For those of us who live and breathe venture capital business models, this is a bad sign: they lead to mediocre results for startup founders, limiting the amount of angel investment they will be able to do, and driving startup funding out of funding. Startup ecosystem.

Such an early exit would also limit the potential positives of venture capital. A company that later exits at a much higher valuation increases the chance of making a whopping 100 times return from a single investment. This, in turn, means that limited partners (i.e. people who invest in venture capital firms) see lower returns. Over time, LPs will get bored of it; The whole point of venture capital as an asset class is to take incredibly high risks, for the potential for ridiculously good returns. When limited partners go elsewhere for their high-risk investments, the entire startup ecosystem collapses due to lack of funds.

There is a possible solution

“We definitely want to try to make the seed tables and Series A caps look ‘natural,’” said Hunter Walk, general partner at HomebrewTechCrunch said. “Investors typically own a minority of the company overall, the founders still have ownership intact, which they invest, and the rest of the common stock is owned by the company/team/complex [stock]”.

I asked the CEO and founder of the hardware company in question how the company got itself into this mess. He requested that his identity not be revealed so as not to expose the company to danger or leave his investors in a bad position. He explains that the team had a wealth of experience in large companies but lacked experience in the startup world. This meant that they did not know how much work it would take to get the product to market. Internally, he said the company had accepted terms “for this round only” and would seek a higher valuation for the next round. Naturally, as the company continued to face delays and problems, the investors made a tough deal, and facing the choice of running out of money or accepting a bad deal, the company decided to accept the bad deal.

The CEO says the company is building a solution to a problem afflicting 1.7 billion people, and that the company has a new product patent-pending that has been successfully tested for six months. On the face of it, it looks like a company with billion-dollar potential.

The current plan is for the company to raise its current $5 million round, then try to correct its cap schedule later. This is a good idea in theory, but the startup has ambitions to raise money from international investors who will have some opinions about the cap schedule itself. This may raise questions about the founders themselves.

Cleaning the table cover

“Such ‘clean-up’ situations are certainly not automatic ‘passes’ but require that the company and capital schedule be comfortable with some restructuring in order to fix the incentive structure along with financing,” Walk said. “If we feel it will be nearly impossible to reconcile (even if we play the ‘bad guy’ on behalf of the founders), we often advise the CEO to resolve the issue before raising more capital.”

Mary Grove of Bread & Butter Ventures agrees that it’s risky for founders to own too little of their company at the seed stage — and in particular for investors to own the other 66%, rather than some of the shares going to key employees.

“We want to understand the reasons why the company made this early dilution. Is it because they were in a geographic area with limited access to capital, and some of the early investors — either no venture capital experience or bad actors — took advantage of that?” ,” Grove told TechCrunch. “Or is there an underlying reason in the business that has made it really difficult to raise capital (look at revenue growth/decline, has the company made a major pivot that has it essentially starting from scratch, have there been some lawsuits or other challenges)? Depending on Reason being, we can move forward to find a path forward if the business and team meet our candidate for investment and we believe this is the right partnership.

Bread and Butter Ventures likes to see founders collectively own between 50 and 75% at this stage of the company — the opposite of what we see in the clone above — Grove said, noting that this ensures interests are aligned and that founders are given the discretion and incentive to build over distance. Upcoming venture-backed company. She suggests that her company have a term sheet that includes corrective actions.

“We like to require that founders receive additional option grants to raise their ownership to a combined 50-75% before we lead or invest in a new round,” Grove says, but she notes the challenge with this: “This doesn’t do that.” It means that existing investors on the cap table will also participate in the overall dilution of this reset action, so if everyone is on board with the plan, hopefully we can all be aligned on the path forward to support the founders and make sure they take ownership to execute on their big vision and take the company to a big exit. .

Ultimately, the overall risk picture depends on the specifics of the company, and depends on how capital intensive the company will be in the future. If another raise can bring the company to cash flow neutral, with healthy organic growth from there, that’s one thing. If this is a type of business that is going to remain capital intensive and will require multiple rounds of significant financing, that changes the risk profile even more.

Rewind options

The CEO told me that the company’s first investor was a large independent research organization in Norway, which often forms its own companies based on technological innovations it has developed. But in the case of this company, it made outside investment on what the founder now describes as “below market terms.” The CEO also mentioned that existing investors on its board proposed raising money at low valuations. Today, he feels remorse, realizing that the choices could jeopardize the company’s long-term success. He said he suspected venture capitalists didn’t believe his company was investable, and making sure that issue was top of mind for future investors was why he put the cap table as a segment in the slide deck in the first place.

The problem may not be limited to this founder alone. In many emerging startup ecosystems – such as Norway – it can be difficult to get good advice, and the “norms” are sometimes set by people who don’t always understand what a project model looks like elsewhere.

“I don’t want to alienate my investors; “They do a lot of good things, too,” the CEO said.

Walk says that bad actors, unfortunately, are not as rare as he would like, and that Homebrew often encounters situations where an incubator or accelerator owns 10% or more on exploitative terms, or where it owns more than 50% of the company that has already been sold to investors, or where Allocating a large portion of shares to fully-fledged founders who may no longer be with the company.

The result could be that if non-local investors want to invest in early-stage ecosystem development companies, they have an amazing opportunity: by offering more reasonable terms to promising early-stage startups than local investors are willing to offer, they can choose the best investments and leave investors alone. Locals fight over scrap. But the obvious downside is that this would represent a massive financial drain on the ecosystem: instead of keeping the money in the country, the wealth (and perhaps talent) goes abroad, which is exactly what the local ecosystem is like. Trying to avoid.

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