At a recent event, we put this crucial question to some of the most qualified cap table experts we know: Rob Moffat, Partner at Balderton Capital, Mo Mirza, CFO at TrueLayer, Richard Abrahams, Growth Lead at PwC and Ed Keelan, Investment Principal at Octopus Ventures.
Over the course of an hour, each expert drew on their personal experiences and in-depth understanding of startup financing to offer advice and guidance to founders. The result? Six essential rules to guide your cap table in 2022.
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Our panellists kicked off by discussing common warning signs that a cap table is poorly managed. “There are two sides to it,” argued Rich. “How many people are on the cap table and how manageable and supportive they are. If you have lots of people, it’s not necessarily disastrous, as long as you can keep them under control.” Ed agreed: “When you’re thinking about the cap table, both the personalities and the attitudes around the table matter as much as the specific terms.”
Though a large number of investors might make cap table management a little more difficult, it’s by no means the end of the world. “If you’ve got 20 investors who all get on and agree, that can be manageable,” explained Rich. “If you’ve got two investors who fundamentally disagree on what the exit should look like, it will be far more challenging than having lots of investors all pulling in the same direction.”
Mo expanded on the idea that identifying problematic cap tables is more nuanced than simply counting the number of shareholders. “You’ve got to look at where you are in the growth process and what types of investors you need around the table. Maintaining good relationships with your investors and putting effective processes in place is an easy way to keep things in check.”
Having argued that the number of shareholders on the cap table isn’t as important as who those shareholders are, our panellists went on to highlight the instances in which a long tail can be problematic. “There are some people who are quite religious about the number of shareholders you should have on your cap table. That’s never been my approach,” declared Rob. “For me, the acid test is whether all the individual investors need to sign something for the company to get acquired.”
This introduced the idea of problem shareholders and how a long tail can slow down important decisions. Several of the panellists had seen shareholders effectively holding a company to ransom because it needed their signature to move forwards. Ed said that his personal experience had taught him a valuable lesson. “If you do have a long tail of shareholders, think very carefully about how you’re going to deal with them and what rights they have.”
Mo also picked up on this potential power imbalance. “Issues arise when you fall out and suddenly realise an investor has nuclear controls over your company.” For him, it all comes back to selecting who you work with very carefully. “In the early stages, you may have been raising money from one or two investors who do have more leverage and can impose conditions on you. It requires you as a founder to be a little more wary and circumspect about who you work with and what their motives are.”
Moving on from looking at the number of investors on a cap table, our panellists turned to the issue of co-founder equity. “It’s certainly a big cap table disaster when someone comes to us raising for a big round and the founder holds just a few percent of the company. That’s not much incentive,” admitted Ed.
Rob added that Balderton Capital also takes a keen interest in the amount of equity co-founders hold. “We don’t usually like to see a founder come up with an idea but then bring someone in to run the startup, so the founder doesn’t do much but owns a big chunk of the company – and the person who actually runs it only holds a few percent. Founder ownership is really important.”
Pressed to put a concrete figure on how much equity co-founders should hold in a healthy cap table, Rich offered a caveated answer. “It differs based on the stage of the company, how much they’re attempting to raise and what the expectations are going forwards. The general rule of thumb is that going into a Series A, you want more than 50% between the founding or management team.”
Mo expanded on the idea that circumstance plays an important role in determining what a good ownership figure looks like. “It depends on the market you’re operating in and what the overall exit opportunity is. If you’ve got 10% of a million-dollar business or 10% of a hundred-million-dollar business, the exit is going to be quite different. You need to think about what the exit potential is and where you want to end up in terms of ownership at that point.”
Throughout the discussion, our panellists regularly emphasised the value of simplicity. This can be applied to the number of investors on your cap table, who they are and what type of shares they hold. Rob picked up on this final point in particular. “You’ve got to keep it simple. Pari passu is the idea that all shares are equal, so you’re paying back everyone at the same rate. I love the simplicity of that. With preferences, you can end up with a very misaligned board and that gets messy.”
Mo agreed that erring on the side of simplicity is good advice. “It’s tempting to try and overcomplicate to drive the right kind of outcome but, generally, the simpler the better. It’s easier to manage and everyone understands the direction you’re going in.”
Our speakers highlighted three specific areas in which simplicity and clarity are key: convertible notes, participating preferences and the waterfall. However, Ed picked out preferences as potentially the most problematic. “You can go in with an investor on a strong preference. But if you think you’ll need more investment from another investor at a later date and the first investor can’t do that second round, you’re lining yourself up for a disaster. They’re not going to give up their preference for nothing.”
Many cap table mistakes stem from a lack of understanding about the way equity works. As a result, our panellists were keen to encourage founders to seek out professional advice on how to manage their cap table. They also suggested that some responsibility lies with investors.
Mo suggested that investors often overestimate founders’ understanding of cap tables. “There are founders who really aren’t that experienced with equity. Often, you’re speaking to product or commerce-focused founders who have little experience of corporate finance and setting up companies in this kind of way. As an investor, you have to be so careful in explaining everything to them.”
Rob wholeheartedly agreed with the need for professional advice. “You’ve got to make sure everything is explained in clear English upfront, rather than expecting founders who don’t come from an investing or finance background to just understand. I’m sure there’s an ideal scenario where there are very few shareholders, management holds a lot of the equity and you have great shareholders around the table who add a lot of value. But a lot of the time that’s just not the case. So it’s more about the logistical management of people and making sure a good lawyer who understands this space has their eye on things.”
To wrap up the webinar, the panellists spoke about the need for founders to build their businesses on strong foundations and demonstrate constant cap table vigilance. Ed commented on the way decisions you make early on in the startup journey can have a significant effect on your business and determine your financial return on exit. “Cap tables can be complicated and the decisions you make early on are going to impact what happens in the future. So spending a bit of time educating yourself on the cap table and really trying to understand what goes into it will pay itself back in the future.”
Rich also argued that founders need to be focused on their cap tables as they build. “Much earlier than most founders realise, you need to surround yourself with good people who understand the startup space and understand investment mechanisms. You don’t want to work very hard for five or six years and reach the end only to be disappointed.”
Mo signed off by reminding founders that, when it comes to cap tables, a little paranoia can be healthy. His advice was to aim for good visibility on your cap table and to ensure that your perception reflects the reality of the numbers. Finally, Rob concluded the discussion with a nugget of wisdom that all startup entrepreneurs should keep in mind. “If you do have problems with your cap table, now is the time to fix them.”