Why Do Cap Tables Kill Startup Companies?

December 2, 2016

By  John A. Moscati, Jr. and David J. Colligan

As lawyers practicing in the startup space, our clients often come to us with less than perfect cap tables.  Some don’t even know what a cap table is.  A cap table is a spread sheet that shows the ownership of the company by class of owner, timing of investment and various rights held by owners of the capital stock of the company.  To an experienced investor, a cap table tells the story of the company.  Like all stories, it has a beginning, middle and end.  By reading a cap table and asking questions based on its content, an investor can see when the company started, who the founders were, when significant pivots occurred, how much capital has been raised, and when.  Unfortunately for many entrepreneurs, they have written the story of their companies by issuing equity and granting various rights to founders, friends, family, and early investors, without an appreciation of how potential future investors will “read” this story.

If a startup wants to create a cap table spreadsheet, we advise them to identify shareholder groups by class (i.e., founders, angel investors, friends and family, etc.); and to include number and class of shareholders or shares or units issued followed by percent of outstanding, and if applicable, percentage of ownership fully diluted.  Where applicable, footnotes should disclose any conversion right or other preferences and any options, warrants, option pools or other rights to acquire equity should be disclosed (and included in the “fully diluted” calculations).

In reviewing cap tables, a number of issues repeat themselves from company to company.  Frequently the issues could have been avoided or at least minimized by obtaining experienced counsel from the outset.  Unfortunately, the reality of limited startup budgets and the proliferation of “do it yourself” formation services, results in many entrepreneurs having to clean up a cap table after the fact, or try to convince an investor to look past a less than perfect cap table.  Maybe the most common cap table problem is the existence of large pools of dead equity.  Dead equity is stock owned by a former founder or former employee who is no longer with the company.  To an investor, this is equity that was not paid for but has equal rights to the equity the investor is buying.  To an entrepreneur, dead equity is a percentage of the company that has been “lost.”  It is not available to help raise new capital, and in the most egregious cases, it serves as a disincentive to management and contributes to a break down in the alignment of interest between management and investors.  Management should be incentivized to increase shareholder value but will lose this incentive if they own too small a percentage of the company, or if management believes their hard work is unfairly benefitting former founders and former employees.  The best way to guard against dead equity is to create Founders Agreements amongst the founders and to use incentive equity agreements with employees.  These agreements can create vesting schedules and grant the company buy back rights ensuring that equity can be required by the company if the recipient departs prematurely.

Another common cap table mistake is the inclusion of non-accredited investors in early investment rounds.  This has the combined effect of increasing the compliance cost of the early round and putting a chilling effect on future rounds because of potential liability concerns.  Disclaimer requirements for sales to non-accredited investors are significantly more extensive than for sales to accredited investors, and future investors frequently view non-accredited investors as unrealistic in their expectations when hard decisions must be made.

A third common error is the intentional or unintentional granting of anti-dilution and other rights to early participants who are not providing value commensurate with the rights received.  Issuing a specific ownership percentage or a right to acquire a stated percentage of ownership causes problems when future capital is raised.  Investors may claim a right to maintain the stated ownership percentage, or claim to be non-dilutable.  In some jurisdictions investors will receive statutorily granted dissenters rights and pre-emptive rights, if appropriate provisions are not included in formation documents.  These investors may have the right to participate in future rounds, or to “put” their shares to the company in certain circumstances.  Finally, poorly drafted documents may create conversion rights or “back-end” rights that effectively allow a party to participate in equity upside without taking on the correspondence equity risk.  All of these additional rights should demand a premium payment from the investor.  Only real money investors should obtain these rights.  A well drafted investor agreement negotiated by the startup company’s attorney can avoid these problems.

If you want to keep from having your cap table kill your startup, our advice is to follow two simple rules.  First, document with a written agreement each person’s rights with respect to their equity ownership, whether it’s a founder, friends and family investor, or angel investor.  Second, don’t unnecessarily complicate the cap table.  Always ask yourself if the benefit being received by the company will justify having to explain the corresponding cap table entry to a potential future investor.  While a well-cared for cap table will not necessarily attract investors, employees, and lenders, a neglected cap table can turn them away.