Four Cap Table Red Flags That Can Kill a Deal

By tremendousblog on July 31, 2024

Deep in the bowels of a startup's data room, there's a critical document: the cap table. A problem with this document can kill a financing. Let me run you through 4 common cap table problems so you can avoid them.

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1) Dev Shop or Venture Studio on the Cap Table.

Here's something you never want to hear: "What's ACME Ventures and why do they own 40% of the company?"

Some startups come out of a venture studio. These programs are a lot like accelerators, except they take way more equity.

A typical accelerator like YC takes about 7% of your company. 40% is outrageous.

If YC, the best program in the world, gets 7%, why should any other program get 40%

The problem with a venture studio owning so much of a company is it leaves way less stock for the founders. And they're the ones actually doing the work.

Some startups give a huge slug of equity to another group of predators, the dev shops. These agencies help build your product.

I recommend against using them even if they don't take equity. But if they take a big slice of your startup, it's an absolute nonstarter.

2) No CTO With 10% + Equity. A true founder owns at least 10% of the company at seed stage. When I see a startup that doesn't have anyone technical at 10% + ownership, I get worried.

Who will keep building product if this company runs out of money? Hired help will run for the hills.

Only someone incentivized with a big chunk of stock will keep working even without a salary.

A lot of startups are hiring a Founding Engineer or Lead Engineer, giving them a couple percentage points of equity, and calling it a day. No bueno.

I also see an engineer being named "CTO" but without the ownership to back up that title. An engineer with 5% equity isn't a true CTO.

3) Departed Co-Founder Owns Too Much Stock. Sometimes, a co-founder decides this whole company building thing isn't for him. I get it — the late nights, the crappy (nonexistent?) pay, who could blame him?!

But you don't want that guy owning a fat slice of your company. You want to reserve that stock for people who are actually contributing day to day.

You can solve this problem by vesting everyone's shares over 4 years, as most tech companies do. This way, you don't reward people for work they haven't done.

If you messed this up and a departed co-founder owns a larger chunk, you can still recover. So long as they don't own over 10%, it's usually not a problem when you go to raise money.

4) Founder Equity Too Low. To make a startup a big success, founders will have to work day and night for a decade. If we expect them to do that, they better have appropriate incentives.

At the early stages, founders should own the large majority of the company. At the close of a seed stage funding round, the cap table might look like this:

Founders: 60%
Employees: 20%
New Investors: 20%

I've seen seed stage companies where the CEO's equity was 10% or less. That means that after many more funding rounds, the CEO would own next to nothing at IPO.

You can't get someone to work 100 hours a week if they don't own a meaningful piece of the company.

Wrap-Up

All these cap table problems come down to founder incentives. We want to assemble the right team and give them strong incentives to succeed.

This means we need builders, and we need to give them serious ownership. We can't waste ownership on venture studios, dev shops, or people who don't work here anymore.

In the early stages, keep your cap table tight and founder ownership high.

If you do this, you'll make more money. You'll also find it easier to fundraise!

What cap table problems are you seeing out there?

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