Here’s what founders should do when the cap table gets messy

In part one, we looked at what cap tables are and why they’re important, as well as four common errors startup founders make. This second part looks into three more errors and how to clean up a messy cap table.

More cap table mistakes founders make

1. Tech vendors

Early in the life of a startup, it may seem like a good idea to pay for things with equity rather than with cash. Cash is in short supply, equity is cheap, and there is a lot of it. So, startups often pay vendors (e.g. an outsourced developer) in equity or in a mixture of cash and equity. This is almost always a mistake and generally does not end well.

The first problem is that it’s difficult to price the equity properly at this stage, so if the company is successful, it will turn out that they sold the equity too cheaply. The second and more important problem is that the equity held by the vendor is dead equity: it was likely sold below market price, and the shareholder will not be contributing any future strategic value after their project is done.

It’s much better to bite the bullet, bring on board a good chief technology officer ASAP, and have him develop the first version of the product. Although it may take a little bit longer, it’s worth it in the long run.

Investing (vested) equity in a strong CTO is one of the best uses of equity for an early-stage startup.

2. Too many small investors

It was the same sad story. I liked the product, the market opportunity, and the team (they were former students). But their cap table was one of the messiest I had ever seen. They completed an angel funding round where they raised a few hundred thousand dollars. They also had 25 shareholders from that round, leaving the active management team with only 28% equity.

When the company has a cap table like this, we are not going to invest. In fact, no one is ever going to, because:

• Having 25 small shareholders is a logistical and practical nightmare. For example, whenever the company needs to have any documents signed by all shareholders, they must chase down 25 signatures. And what happens if they can’t find one of these 25? Also, every shareholder in a company has the potential to become a problem shareholder, so this company has 25 problems waiting to happen.
• The founders have been overly diluted by their angel funding round. After that round, we would have expected founders to have at least 90% equity.

3. FF&F

The first round of external funding for a startup usually comes from friends, family, and fools (FF&F). We see quite a few cap table messes attributable to this round.

Problems with friends and family

Friends and family typically invest because they love and trust the founders, which is a good thing. Unfortunately, this trust often results in undocumented or unclearly documented investments or loans to the startup.

We recently encountered a founder with this kind of undocumented loan from his sister. The conversation went like this:

How to clean up a messy cap table