After my recent post about what kind of revenue matters most for investors, I would like to discuss common issues involving cap tables. In particular, I want to explain why your company is likely already dead owing to that last round of financing.
When preparing for StartupBanking.co events with founders and the angels I work with at Angel Academy, I find myself repeating the same line time and time again: Building a successful company is extremely difficult, but killing one is very easy. All it takes is one funding round, at the wrong terms, from the wrong investor. I’ll explain why below, but first let me explain some fundementals.
Understanding your cap table
It boils down to this: Your cap table is an overview of who owns how many shares in your company. With each new funding round, brand-new investors get a piece of your company, and your cap table changes. When an investor asks you for an overview of your cap table, they want to see a list of all shareholders in your company plus how many shares they own. Together, all these ownership stakes add up to 100%.
Investors want to see your cap table not (only) to see who owns shares in your company, they also wish to see what type of people own shares in your company. In particular, you want to make a distinction between:
- Founders (i.e., people who founded the company and still work in the company)
- Note: Your co-founder who is now in Ibiza and no longer working for the company does not count here. Shares owned by that founder are described as dead equity.
- Angel investors (i.e, people investing their own money)
- VC’s (i.e., people investing other people’s money)
- Accelerators (if applicable)
- Service providers who you have paid in shares (please don’t, this is not advisable!)
Experienced early stage investors want the first two categories to be as large as possible. Most companies who have not raised a Series A or Series B round rely, in varying degrees, on the energy and motivation of the founding team.
It is, therefore, in the best interest of the investors to minimize the risk of the founders walking away. If founders walk, a young company is often unable to attract new, high-quality leadership. Young companies are risky ventures and offer low pay. This is unattractive to most experienced executives, which is why they will not join a startup to replace founders who have left.
The probability of founders walking away from their company is always there. The first few years of starting a company are unrelentingly hard. The hours are long, the emotional rollercoaster is shocking, the salary (if at all available) is low, and the odds of success are slim. In addition, a talented founder will always have the option to walk away and earn more than €100k per year for half the amount of hours if they join a large corporate venture. The fact they do not do this very often, is, quite frankly, amazing.
A tale of two cap tables
Aside from passion, one reason founders do not leave is because of their shares. Imagine two scenarios for a company that, in theory, could be acquired in 10 years for €100M (and where there is a 10% chance this will actually transpire).
- Scenario 1: The founder owns 50% of this company. Today, the theoretical value of his or her ownership is €5M (€100M * 10% probability of success * 50% ownership), or about €500k per year.
- Scenario 2: The founder owns 10% of this company. Today, the theoretical value of his or her ownership is €1M (€100M * 10% probability of success * 10% ownership), or about €100k per year.
When things get tough, and they always do, the founder in the second scenario will likely walk. An experienced investor is not just worried about you leaving today, but also has an eye on the future.
As your company matures, it will require increasingly large funding rounds. This means you will be talking to increasingly professional and sophisticated investors. When you are raising your €5M-€10M Series A round, those investors will have their own set of criteria to determine if your company is an attractive investment.
As a result, a short route to a quick ‘no’ from these investors is a cap table where the founders do not appear to be properly incentivised. If the founders do not have enough shares, great investors will not invest. Bad (or inexperienced) investors may move forward but you do not want bad investors. The key takeaway: You will never access large pools of capital, managed by amazing investors who can really help your company, if you have already given away too much equity.
Enough equity to go around
If you do not have access to exceptional later stage investors, reaching the required scale to effectively sell your company becomes next to impossible. By cutting off access to these sources of capital, your company is effectively already dead. It has been killed by selling too much of your company today, leaving too little to attract large pools of capital later on.
Now you may be asking, but if this is the case, why do some early stage investors kill your company like this? Well, it’s not malevolence. Investors who have access to a limited number of datapoints often do not understand the damage they can cause in the long term.
Especially outside of main hubs like London, Berlin or Paris, inexperienced angel investors will feel quite happy that they have bought 30% – 50% of a young company. But investors should not feel happy; instead, they should feel some embarrassment. If your (pre-seed) stage investors are demanding such high amounts, feel free to share this article with them or have them reach out to me.
In other cases, messy cap tables result from (too many) bridge rounds. Plenty of founders raise a round from angels, and then need ‘a few €100k more’ to reach a certain scale to become of interest to VCs. Founders on this trajectory should understand that each additional bit of dilution brings them a step closer to the problems outlined above. Angels who invest another €100k to ‘protect’ the initial €500k they invested should know they have broken one of the key laws of investing, never throw good money after bad.
Are you an (aspiring) angel investor, and do you want to avoid making decisions that kill companies in the long run? Participate in our Angel Academy courses and join our network of over 150 alumni. Looking to benchmark whether a particular share of ownership is relatively high or low for a particular funding amount? Have a look at Benchmarking as a Service!