The deadly sins of messy cap tables and how to avoid them

In my last article, I talked about how overvaluation can kill good startups. Now, I want to look at an easily preventable phenomenon that is also killing good startups: messy cap tables.

In our first meetings with startups now, we routinely ask about their cap table. Way too often, a promising startup pitch dissolves into a no-go after they describe their cap table.

To understand how these messy cap tables are hurting startups, we need to know first what cap tables are, why they are important, and what a clean cap table looks like. Then, we look at the various kinds of mistakes founders make and how to clean a messy cap table.

Spoiler alert: Keeping a cap table clean is much less painful than cleaning it once it has become messy.

What is a cap table and why is it important?

A cap table shows the distribution of ownership in the company both before and after an investment. It also shows potential ownership in the form of any options or other equity-convertible instruments (fully diluted, as converted basis).

Cap tables are important because equity is the primary economic motivator for startup founders, key employees, and venture investors. Founders and key employees generally earn much lower salaries than they would working in a large company, often for many years. They are willing to do so because they own equity in the startup, which will be worth a lot more than their foregone salary if the startup makes it to a successful exit. Investors are generally in the same boat.

As equity is so important to founders, key employees, and investors, a clean cap table should include only them. A messy one includes anyone other than them.

The equity percentages of founders, key management team, and investors can be in double digits (e.g. 10% to 99%). Anyone else who holds equity should do so in single digits (e.g. 2%) or less.

Another way to understand this situation is to realize that there are only two primary uses of equity:

1. To motivate the management and key employees to help grow the company
2. To sell to investors to fund that growth

Equity that is not held by the active management team, key employees, and investors is considered “dead equity.” Too much dead equity can kill even the most promising startup.

Investors like to see a clean cap table, with all or close to all the shares owned by the key holders defined above. Any variations from this – cap tables containing inactive founders, “part-time founders,”  “strategic advisors,” and the like – will constitute a messy cap table, which will almost certainly need to be cleaned up before the next round of investment.

Here’s an example of a clean cap table for a seed-stage company:

How does a messy cap table look?