Cap Table Mistakes to Avoid

Quick question: How would you react to a cap table of a seed-stage startup looking to raise its Series A, where the investors hold almost 70% of the equity and only 30% held by the three co-founders combined?

Well, when Leslie Feinzaig, general partner at Graham & Walker, was asked the same question, he had only one response: 

“This cap table has one giant red flag: The investor base owns twice as much as the three founders combined do”. “I want founders to have a lot of skin in the game. The best founders have a very high earning potential — I want it to be unquestionably worth their time to keep going for many years after my investment in them … I want the incentives to be completely aligned from the get-go.”

We are talking about a Norwegian hardware company that shared its pitch deck and cap table with TechCrunch. The company had given up over 2/3rd of its equity to raise $3.3 million and was now looking to raise another $5 million round.

Sometimes, investors can be greedy and try to take up a majority share in a relatively small funding round.  While it seems like a good thing for them because they get more ownership for less money, in reality, it isn’t. When investors take too much, founders end up with very little. This directly impacts the investors' payout, because now founders aren't motivated enough. It no longer remains the founder's company but becomes the investor's. It often results in the company taking an early exit, than it would otherwise, limiting the potential upside for investors.

Why is a correct cap table important?

For any startup, a cap table is the holy grail of ownership and corporate governance. It's a dynamic document that tracks who owns what piece of your company, reflecting the distribution of shares among founders, investors, advisors, employees with stock options, and any other stakeholders.

A well-maintained cap table is the foundation for smooth fundraising rounds, future exits like acquisitions, and ensuring fair ownership dilution as your company grows. Here are some reasons for you to maintain a correct cap table:

‍1. Transparency and trust

Imagine this: You're pitching to a potential investor, and during due diligence, they discover discrepancies in your cap table. It doesn't inspire confidence, does it? A clear and accurate cap table fosters trust with investors and stakeholders. It demonstrates a company's professionalism and ability to manage complex financial data.

‍2. Informed decisions

If you're thinking about expanding your stock options pool, having an accurate cap table with current ownership percentages is crucial. This helps you make smart decisions about how much more equity to offer without inadvertently diluting ownership too much.

‍3. Smoother fundraising

Investors perform thorough due diligence, which includes scrutinizing the cap table. An error-ridden cap table can raise red flags and delay or derail funding. Imagine spending months preparing for a funding round, only to have it held up because your cap table shows you accidentally gave your cousin Billy Bob 5% ownership for "helping out" in the early days.

4. Reduced conflict

A clear cap table minimizes ownership disputes. For example, if there's confusion about the co-founding split (think Mark Zuckerberg and Eduardo Saverin in "The Social Network"), it can lead to a major falling out and potentially even legal battles. 

Read our cap table management guide to know more.

Consequences of an outdated cap table

Failing to maintain an updated cap table can be like trying to navigate a maze blindfolded.

Here's what can go wrong:

‍1. Dilution surprises

Founders may be unexpectedly surprised by the level of ownership dilution during future funding rounds due to inaccurate calculations. Let's say you think you own 70% of the company, but your outdated cap table missed an angel investor who received a 10% stake. Suddenly, your ownership shrinks to 60%, which can be a shock when negotiating terms with a venture capitalist.

‍2. Investor disputes

Inaccuracies can lead to disagreements with investors about ownership percentages. Imagine a scenario where an investor claims they own 15% based on an old term sheet, but your cap table shows 12%. This can damage trust and potentially lead to expensive litigation.

3. Legal issues

Outdated cap tables may not reflect legal agreements regarding shares, options, and vesting schedules. Discrepancies can lead to legal challenges and financial losses. For instance, if a former employee with stock options sues because your cap table doesn't reflect their vesting schedule, it can be a costly mess.

‍4. Missed opportunities

An inaccurate cap table can make it difficult to attract new investors who may be wary of ownership discrepancies. They might take their money elsewhere if your cap table looks like a house of cards ready to collapse.

Common cap table mistakes companies to avoid

Now that we have understood how critical it is to have a well-maintained cap table, let’s understand some common mistakes that people usually make:

‍1. Managing cap table on spreadsheets

We can’t say this enough, but if you are managing your cap table on spreadsheets, 9/10 you will have some errors in your calculations,especially if your ownership structure is complicated. They become unwieldy as the company grows and transactions increase. Imagine a complex cap table with convertible notes, priced rounds, and stock option pools all crammed into a single spreadsheet.

Let's say you issue 100,000 shares at a price of $1 per share, but your spreadsheet accidentally rounds down to $0.99. That tiny difference can throw off ownership percentages, especially for large funding rounds.

Hence you must always use a cap table and equity management software like EquityList to ensure all your calculations are correctly reflected. 

2. Inaccurate share calculations

Incorrect share price calculations, such as mistakenly calculating the share price based on an outdated valuation or an oversight in adding back the unvested stock options of a terminated employee to the ESOP pool, are some common mistakes that people usually make.

This might lead to incorrect share price calculations and dilution percentages, failing to give you the true picture of your equity issuances.

3. Missing shareholder data

Incomplete information on shareholders, including contact details and vesting schedules for stock options, can create communication problems and hamper future transactions. For example, if you can't find an angel investor's contact information to buy back their shares, it can stall an acquisition or IPO. Maintain a comprehensive shareholder list with accurate details. 

4. Inconsistent dates and agreements

Discrepancies between the dates listed in your cap table and those reflected in legal agreements (like term sheets or stock option agreements) can sow confusion and potentially lead to legal disputes. Ensure all dates in your cap table are consistent with corresponding legal documents.

5. Address dead equity

Dead equity refers to shares that are no longer actively contributing to the company's growth or value. Proactively identifying and managing dead equity through strategies like buybacks or reallocation ensures optimal capital structure, thus managing equity effectively.

Imagine a startup where a former employee holds a significant number of shares but has left the company and is no longer contributing. This 'dead equity' limits the value the company can extract by reallocating these stocks to active contributors like new investors or active stakeholders. By implementing a buyback program or negotiating to reallocate these shares, the company can optimize its cap table, enhancing its appeal to future investors.

6. Neglecting legal and financial expertise

Complexities around legal agreements, securities laws, and valuation methods can be challenging for founders to navigate alone. Don't hesitate to seek guidance from lawyers or qualified financial advisors for intricate transactions, especially when dealing with convertible notes, stock option pools, or complex funding rounds. Having professional help can minimize the risk of errors and ensure your cap table reflects best practices.

‍7. Ignoring shareholder communication

Keeping stakeholders informed about changes to the cap table is crucial for maintaining trust and transparency. This includes notifying shareholders of any new stock issuances, conversions, repurchases, or changes in ownership percentages. Consider clear communication protocols to ensure all shareholders are kept up-to-date.

By understanding the importance of an accurate cap table and avoiding these common mistakes, startups can ensure smooth financial operations and foster trust with stakeholders. Remember, a well-maintained cap table is a valuable asset that can empower informed decision-making, minimize conflicts, and ultimately contribute to the long-term growth of your company.

‍