The Marie Kondo of Cap Tables
The art of tidying up cap tables, and why it matters
My co-founder Jenny Fielding is the Marie Kondo of capitalization tables, or “cap tables,” as they’re more commonly referred to. A cap table is the system of record that shows ownership within a company. If your company has an owner, then it has a cap table whether you want one or not, and how it looks will determine your company’s long-run fundraising viability, your ability to hire and retain talent, and much more.
At Everywhere Ventures we developed this handy overview on Cap Table Hygiene.
A cap table is made up of a few things such as:
Ownership break down of founders (common stock)
Ownership break down of investors (preferred stock)
Preferred refers to the liquidation waterfall, meaning who would get paid back first in an exit, or liquidity event (acquisition or initial public offering)
For investors, the cap table lists generally initial investment, entry valuation or the price per share equivalent, and percentage ownership
ESOP is the employee stock option pool which denotes how much of the common stock has been set aside to be granted to employees in the form of stock options
Some of the things that are red flags to us when we look at cap tables are:
Founder own too little of their own company to be incentivized to keep building. Especially at pre-seed or seed, there is a long road ahead and founders need to own well over 50% of the company. Typically at least 50% post Series A.
Early investors taking too much equity. Ownership for investors is a function of their entry valuation, so if an investor managed to invest $500k at a $1M post money valuation, the cap table would show that that investor owns 50% of the company. This is an egregiously high amount and makes the startup completely un-fundable. The investor might have felt like a genius inking that deal, but what they got in ownership asset is cap table liability. The company is far too diluted, meaning founders don’t own enough to want to keep building. This is a red flag, and no smart investor will ever fund this company without “re-capping it.” Re cap is a fancy term for cap table clean up, meaning cutting back that early investor by doing things like issuing a new option pool that dilutes their ownership down to a lower percentage, and then granting those shares back to the founder. There are many other ways this shakes out, but it’s not fundable as is without a fix.
No ESOP is a major problem as well. No team is ever complete, and founders always need to fill in gaps and emerging blind spots, and build a team. In order to attract and retain talent the company needs to be able to issue stock options. These stock options come from the ESOP. Without one, you can’t hire people, so when investors push for this it’s not them asking for anything for themselves, it’s them pushing you to build a better team around you, as that’s how we all win. The other fact is most investors will push for the ESOP creation happening out of the pre-money, not the post. What this means is that the ESOP is created before the new investment is made. No investor wants to wire $1M to you, and then have a 10% ESOP created post-investment dilute their $1M invested to $900K value. As such it’s best to just set this up at the start of your company, as the dilution will be felt now or in the future, so might as well face the reality of its necessity.
These are a few quick bullet points and lessons on cap tables that we, and Jenny, go into far more detail in the above overview deck. In coming months we’ll also dive deeper into the iceberg that sits below the cap table water. For example, the ESOP and the stock option grants have terms associated with them like “exercise windows” or the length of time an employee can exercise their right to purchase those shares for a value assigned when they’re issued or fully vested. Something like this is not listed in the cap table, it’s typically spelled out in a new hire letter or stock grant. But what’s interesting about these details is that they also matter later on. For example, if you have a 10-year exercise window on options granted, this is fabulous for employees. They can work, vest, and quit and then have ten full years to decide if and when they want to exercise. Vis-a-vis a one month or twelve month window, this is very advantageous to employees, but it can also devastate founders going through an acquisition where a lot of long-dated, outstanding options might be viewed by the acquirer as liabilities or IOUs owed to employees. These types of things pop up in the due diligence process of an acquisition, and can easily torpedo a deal.
The more you know about your cap table and the details it represents the better prepared you will be to raise money, hire talent, and build a successful company.
Check out Jenny’s fabulous deck on the above link, and more about Everywhere Ventures at our website and founder spotlights each week. For more on KYC, or Know your Cap Table, my friend Rishi Taparia at Garuda Ventures also has a great post.