A tale of a broken cap table

written by Anna Magiera, Senior Partner, Startups & Venture Business

‘We do not invest in companies with a broken cap table’

This is a quote from a VC fund’s website and a phrase I often hear from investors.

Another one that impressed me lately was: ‘Cap table is our Bible’.

I hope this is strong enough for you to understand how important the cap table is for investors and how much it affects the fundraising process outcome.

It hurts when you are losing a chance of partnering with a great investor only because you didn’t think ahead at the beginning of your startup journey.

So let’s start with what a broken cap table really means.

The capitalization table is a breakdown of shares in your startup.

The problems arise if your first investors get too much equity.

This is a common case as in the early stages when a startup has no traction, and the risks are high, valuation is low. Hence, founders might give up 30+% of the equity. And a standard rule of thumb is to give away not more than 10–20%. Because if you are building a venture business, you should plan to raise several rounds, so giving up too much at the pre-seed stage jeopardizes your subsequent rounds. There will not be enough ‘room’ for new investors.

Another problem is that when an early-stage investor gets too much, the CEO can have such a small portion that there will be a question of motivation.

And the CEO is the one person who drives the whole success. That is why it is crucial that he/she is motivated every step of the way.

And don’t forget about ESOP (an employee stock ownership plan), which is a part of equity put aside for the most important team members. That’s a common practice to issue options to those who contribute the most and are valuable for the company. So make sure you have that assigned.

What to do to avoid all this?

First, raise equity funding as late as possible. Wait till your valuation is high enough.

If that’s not an option, consider debt financing — convertible note or SAFE (simple agreement for future equity). Then, you wouldn’t have to stick to the valuation at the fundraising date. To learn more about it, read our article: ‘Direct equity or convertible note, what is right for your early-stage startup?’

Sometimes you could negotiate with early-stage investors that they are participating in ESOP, meaning their shares are also diluted.

Remember, you shouldn’t agree to every offer from investors. You must be picky and know what is good and what is bad for you. Trust me, there are investors out there who want their portfolio companies to prosper and raise following rounds. They won’t break your cap table, as this is not in their favor either.