A few months ago, I helped a local outfit raise money. This company was less than a year old. It had a decent product portfolio, but hadn’t made much progress on sales and distribution. Nor was it producing enough cash flow to pay the bills – it was insolvent. Even though the company had just gotten off the ground, its founders had done a great job of trashing out the company’s cap table.
So, what not to do with your startup cap table?
Here’s what their “cap stack” looked like…
- Class A common stock (with enhanced voting rights)
- Class B common stock
- Restricted stock with company buyback rights (tantamount to vesting)
- Incentive stock options
- Non-qualified stock options
- Stock warrants
- Multiple tranches of convertible debt – each with different conversion prices. Of course, all issues had anti-dilution and down round protection. Even though convertible debt is a “hybrid” debt/equity security, investors look at potential future dilution in a capital raise.
Acknowledgement: Some of the above will likely be necessary to attract talent, and to secure early-stage investment capital.
How Could This Happen?
The company didn’t have much initial funding. The founders were inexperienced, and they were anxious. In the rush to build a team, they went bonkers with equity grants. In this case, the folks receiving equity were new (and unproven) employees, directors, and even consultants. Because of their anxiety and haste, the founders felt like they had to pander to everyone’s specific needs and circumstances. Heck, many of these folks won’t even be with this company in a couple of years! That will be pure joy to unravel. Trying to wade through all of the different equity instruments and figure out “fully diluted” shares for the equity raise was a complete mess. It created unnecessary complexity, and gave investors more wiggle room in their negotiations.
The Moral of the Story…
Keep your startup cap table simple from the outset. Obtain experienced legal and tax counsel, and don’t let them complicate matters. Lastly, don’t offer up equity day one to every employee, consultant or director who can warm a chair and fog a mirror! You can always grant more, but it’s painful to take it back…