A Norwegian CEO The hardware startup shared a pitch deck with me that had an unusual slide: it included a company capitalization table — who owns what part of the company. Generally, cap tables are divided into the labor phase of the investment.
Taking a closer look at the table, something is notably wrong:
![table table](https://techcrunch.com/wp-content/uploads/2024/03/Cap-Table-for-Fictional-Company.png)
This cap table is a recreated, accurate replica of the cap table that was in the deck. It has been simplified and redacted to remove the names of investors. Image credit: Hajj Campus / TechCrunch
The problem here is that the company has given up two-thirds of its equity to raise $3.3 million. With the company starting a $5 million fundraising round, that represents a serious hurdle.
TechCrunch spoke to several Silicon Valley investors, theorizing whether they would invest in a founder who offered a cap table with the same dynamic shown above. What we learned is that the cap table as it stands today essentially makes the company uninvestable, but there is still hope.
Why is this such a big problem?
In a less sophisticated startup ecosystem, investors may be tempted to make short-sighted decisions, such as trying to take 30% of a company’s equity in a relatively small funding round. If you’re not familiar with how startups perform in the long run, this might seem like a sensible goal: Isn’t it an investor’s job to get as much as possible out of the money they’ve invested? Perhaps, yes, but hidden within that dynamic is a real poison pill that can limit how far a startup can achieve. At some point, a company’s founders have so little equity left, that an early death march’s cost/benefit analysis begins to shift against the startup to continue giving it all to them. .
“This is a big red flag at the cap table: the investor base is twice as much as the three founders combined,” said Leslie Fenzig, general partner at Graham & Walker. “I want founders to have a lot of skin in the game. The best founders have a lot of earning potential – I want it to be worth their while to last for years after my investment in them… I want the incentives to be fully aligned after they’re gone.
Fenzig said the company, as it stands, is “essentially uninvestable” until a new lead comes in and fixes the cap table. Of course, this, in itself, is a high-risk step that is going to take a lot of time, energy, money and lawyers.
“Fixing the cap table means weeding out existing investors and returning ownership to the founders,” Fenzig said. “It’s an aggressive move, and not many new investors are going to be willing to go to those lengths. If this is the next OpenAI, they have a fair shot at finding a lead that will help clear this up. But the seed At this stage, it is extremely difficult to stand out so clearly, let alone in the current VC market.
With a non-motivated founder, the company would likely exit sooner than it would otherwise. For those of us who live and breathe venture capital business models, this is a bad sign: it leads to mediocre results for startup founders, which limits the amount of angel investment they can make, enter- Leveling out funding. The startup ecosystem.
Such an early exit will also limit the potential upside for VCs. A company that later exits at a very high price increases the chance of a huge, 100x return on funds from a single investment. This, in turn, means that limited partners (that is, people who invest in VC firms) see lower returns. Over time, LPs will get bored of it. The whole point of VC as an asset class is incredibly high risk, for the potential for fantastically good returns. When LPs go elsewhere for their high-risk investments, the entire startup ecosystem collapses due to lack of funds.
There is a potential solution
“We definitely want to try and make the seed and Series A cap tables look ‘normal,'” Hunter Walk, general partner at Homebrew, told TechCrunch. “Usually the investors are minority owners of the company as a whole, the founders still hold the healthy property in which they are investing, and the rest of the company/team/pool is common. [stock]”
I asked the CEO and founder of the hardware company in question how the company got itself into this mess. He asked to remain anonymous so as not to risk the company or leave its investors in a bad spot. He explained that the team had big company experience but no experience in the startup world. This means they had no idea how much work it would take to bring the product to market. Internally, he said that the company accepted the terms “only for this period”, and will pursue a higher price for the next period. Of course, as the company ran into delays and problems, investors drove a hard bargain, and faced with the choice of running out of money or taking a bad deal, the company decided to take the bad deal.
The CEO says the company is developing a solution to a problem experienced by 1.7 billion people, and that the company has a novel, patent-pending product that it has been successfully testing for six months. On the face of it, it looks like a company with multi-billion dollar potential.
The current plan is for the company to raise the current $5 million round, and then try to adjust its cap table later. In theory it’s a good idea, but initially there are chances of rising from international investors who are going to give themselves some feedback on the cap table. And this may raise questions about the founder himself.
Clearing the cap table
“Situations that deserve a ‘clean-up’ are certainly not an automatic ‘pass,’ but they do require the company and the cap table to be comfortable with some restructuring with financing to fix the incentive structure,” Walk said. . “If we feel it’s going to be nearly impossible to reconcile (even if we play the ‘bad guy’ on behalf of the founders),” we’ll often advise the CEO to resolve it before raising more capital. .”
Mary Grove of Bread & Butter Ventures agrees that it’s a red flag if founders own so little of their company at seed stage — and especially that investors own the other 66%, instead of going for some equity-critical jobs. in lieu of.
“We want to understand the reasons why the company did this quickly. Is it because they are geographically based with limited access to capital and some early investors – either VCs or bad actors – are not experienced. Is — took advantage,” Grove told TechCrunch. Or is there some underlying reason with the business that made it difficult to raise capital (take a look through revenue growth/churn, did the company make a major pivot that essentially started it from scratch, was there some litigation Or is there another challenge. )? Based on the reason, we can find a way forward if the business and the team meet with Filter for our investment and we think it is the right partnership.
Bread and butter ventures like to see the founders own a combined 50-75% of the company at this stage — the opposite of what we see in our top product — Grove said, citing that it’s a matter of interest. Ensures alignment and recognition of the founder. And to encourage the forward distance for the construction company backing the company. She suggests that her firm have a term sheet that includes corrective actions.
“We will request that founders receive additional option grants to bring their ownership to a combined 50-75% before we lead or invest in a new round,” Grove says, but she notes the challenge in Thi: “He does.” This means that the investors on the cap table will also contribute to the overall reduction for this reset, so if everyone is on board with this plan, we will hopefully be able to come together to help the founders on the way forward and make sure that they is the property of To execute their big vision and make the company big.
Ultimately, the overall risk picture depends on the characteristics of the company, and on how much capital the business will have in the future. If one more addition could make the company cash flow neutral, with healthy organic growth from there, that’s one thing. If it is a type of business that will continue to be capital intensive and will require several rounds of significant funding, this further changes the risk profile.
Repeat options
The CEO told me that the company’s first investor was a large independent research organization in Norway, which often builds its companies based on its advanced technology. In the case of this company, however, he made an outside investment at what the founders now describe as “below-market terms.” The CEO also mentioned that existing investors advised his board to raise money at lower prices. Today, he regrets, considering that the choice could jeopardize the long-term success of the company. He said he suspected VCs wouldn’t think his company was worth investing in, and making sure that issue was front and center for future investors was why he slid the cap table into the slide deck in the first place. kept as
The problem may not be isolated to this one founder. In many developing startup ecosystems – like Norway’s – it can be difficult to give good advice, and “soft” decisions are sometimes made by people who don’t always understand what the venture model looks like elsewhere.
“I don’t want to alienate my investors. They also do very good things,” said the CEO.
Walk says that bad actors are, unfortunately, not as rare as he would like, and homebrew often comes in situations where an incubator or accelerator is 10% or more on “exploitative terms”, or where more than 50% of the company is more have already been sold to investors, or where a large portion of the shares have been fully allocated to founders who may not be with the company.
The result could be that if non-local investors want to invest in early-stage companies in the development ecosystem, they have an incredible opportunity: by offering more reasonable terms to promise early-stage startups than local investors, They can choose. Best investment and leave the local investors to fight over the scrap. But the obvious downside is that it would represent a colossal financial drain from the ecosystem: instead of keeping money in the country, wealth (and, potentially, talent) goes abroad, which is precisely the kind of thing that happens. which is the local ecosystem. Try to avoid.
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