Cap Table Mistakes That Can Haunt You Later

Amidst the excitement and hard work of setting up a new company, many entrepreneurs tend to overlook cap table mistakes. Errors in your equity structure can have a long-term impact. When you set out to bring partners, investors, and top talent on board, a messy cap table causes confusion.

Investors consider mistakes in the cap table as a red flag, and you might find it challenging to secure funding. As your fundraising consultant will advise, work on strengthening the equity format from the time you establish the company. Hire legal expertise to ensure compliance with relevant regulations.

Cap table mistakes may not seem particularly important in the initial stages when you’re investing personal funds. However, as the startup progresses to the seed stage and beyond, and you secure external capital, minor errors begin to compound.

You’ll find it harder to fix the problems when they start to stunt the startup’s growth and jeopardise fundraising initiatives. On the other hand, a well-structured cap table provides a clear overview of current ownership and indicates efficient management. That’s an attractive sign for investors.

Understanding What is a Cap Table – A Quick Recap!

A cap table is essentially a breakdown of the startup’s ownership structure, providing an overview of its stakeholders. Also known as the capitalization table, it includes information such as the number of shares issued and their respective holders.

You’ll also add the option pools held in reserve, restricted stock units (RSU), SAFEs, convertible notes, warrants, and more. In addition, you must add the value of the stock each owner holds. Analyzing the cap table helps investors determine whether the startup is a robust investment opportunity or a risk.

Not only does the cap table show what stakeholders can claim in the event of an exit, but it also shows who holds the crucial decision-making rights. This factor is particularly important for potential investors evaluating the company during later-stage funding rounds.

However, they do realize that the cap table is dynamic and changes with every funding round–formal or informal. This is why it’s crucial to update the cap table as the startup evolves and grows. Here’s a quick look at the typical errors to address when formatting the cap table.

Putting Off Creating and Maintaining the Cap Table

The right time to create the cap table is the moment you start building the startup. Even solopreneurs should maintain a cap table and document every investment they make to establish their company. This approach ensures that you record your equity stake in it.

When you bring in partners as co-founders or investors, you’ll add their investment and equity stake in the startup. Also, update the cap table each time you create option pools for employees. Or, when partners leave the company, and there are changes in the ownership structure.

Rely on the advice of your legal team to draw up the necessary paperwork and include data in the cap table. You’ll maintain trust and transparency, which is critical for lasting relationships. Delays result in avoidable cap table mistakes, leading to misalignment and a lack of accountability between partners.

Lack of Planning for Dilution and Future Funding Rounds

A well-managed cap table should account for not just current ownership, but also plan for future funding rounds. Each time you run a fundraising campaign, you issue new equity, resulting in dilution for existing stakeholders.

You’ll create the framework for the funding round based on the cap table by comparing different valuation probabilities. Ensure you factor in the impact of the new equity on ownership, which will help you calculate the funding amount. This strategy enables you to make informed decisions.

You’ll offer anti-dilution provisions to the key stakeholders to maintain their trust. Further, consider how dilution will impact option pools, as unexpected dilution can negatively impact employee morale. You may find that the uncertainty makes it more challenging to retain top talent.

Utilize your cap table to model various scenarios and safeguard employee rights while maintaining transparency about your dealings.

Overlooking Vesting Schedules

When you offer option pools to employees, they come with vesting schedules. Vesting is a process that allows employees to claim ownership of their shares over a pre-determined timeframe. Founders use these schedules as incentives for top performance or to complement their salary structure.

Be extremely cautious about how you structure vesting schedules in the cap table. Early employees can leave the company and take a large chunk of equity with them. This can pose a significant risk if they have worked in the company for a short time only.

Investors scrutinize vesting schedules, as they can lead to conflicts, disputes, and the potential for unexpected dilution. Employees owning stock can sell it in the open market to third parties. This is why investors are wary about how options can dilute the value of their equity.

With the advice of the legal team, you’ll structure vesting schedules with a one-year cliff and four-year vesting. You can not only adjust the schedule based on the startup’s needs but also get assistance with documentation. Not having the paperwork in place is another of the crucial cap table mistakes.

Ensure that you draw up binding agreements to prevent legal issues arising from disgruntled employees. In this way, you’ll also reassure potential investors that their interests are taken care of. At the same time, you’ll correct another of the cap table mistakes that can haunt you later.

Getting the cap table right is only one of the many aspects. If you’re looking for more information on how to raise startup funding, check out this video I created.

Missing Option Pools

Failing to manage vesting schedules strategically can be costly for your startup. However, on the other hand, not having option pools is also a downside. As the company grows, you’ll set aside option pools to attract and retain top talent. Having a great team on board is crucial for the company’s long-term success.

Skilled executives expect performance-driven incentives in addition to a competitive salary structure. Without it, you might lose out on getting much-needed expertise for the company. Key team members see option pools as the company’s commitment to rewarding them for their work.

A typical option pool comprises around 10% to 20% of the company’s fully diluted shares. You’ll reserve it before running the funding campaign. This strategy solves two core issues.

Firstly, it reassures investors that their ownership stake is secure against potential dilution. This dilution can happen if you create an option pool later. Secondly, an option pool on the cap table indicates team retention, an important consideration for investors.

They need to see that top talent will remain with the company and ensure its continued growth and success. Reserving the option pool early on also eliminates administrative hurdles.

That’s because setting up the pool requires the board and existing shareholders to sign off on it with formal approvals. Also, ensure that you structure and manage the pool strategically.

A small pool makes it impossible to retain talent, and a large pool results in unnecessary dilution. This is why you’ll work with the legal team to balance and structure the pool. Its exact size depends on investor expectations, the stage the company is at, and the team you expect to hire.

Maintaining Dead Equity/Inactive Stakeholders and Micro-Investors

Dead equity refers to inactive stakeholders who own shares but no longer actively contribute to the company. These stakeholders can include ex-employees who have left the company, angel investors, incubators, accelerators, or other entities. They may have invested in the startup in its seed stages.

Also, identify other stakeholders who don’t add value beyond financial contributions. Or, those investors that create a negative impression by appearing on the cap table. Now that the company is poised to ramp up growth, you should eliminate them by purchasing their stake.

Dead equity is another of the cap table mistakes you’ll address as it unnecessarily complicates the structure. Potential investors may see it as a red flag. That’s because it confers decision-making rights on shareholders who are no longer aligned with the company’s goals.

Yet another investor class to address on the cap table is micro-investors, each holding a small stake. Multiple individual investors can make the cap table complex and confusing, and managing them takes time and bandwidth. Consider combining these investors into a single special-purpose vehicle.

A special purpose vehicle (SPV) appoints a qualified nominee to make decisions on behalf of the smaller investors. You’ll declutter the cap table since the SPV appears as a single entry and lowers administrative tasks. All communications are directed to the representative, simplifying proceedings.

Potential investors appreciate the streamlining of decision-making rights and diverting them to an accredited individual.

Missing Agreements and Documentation

When issuing shares, ensure your legal team drafts binding agreements and accompanying paperwork. Proper paperwork is essential for maintaining accurate records of deals and avoiding the risk of legal hassles and disputes over ownership. Avoid relying on verbal agreements that cannot be enforced in court.

Transparency is key to avoiding misunderstandings and strengthening the equity structure. The relevant parties must sign all term sheets and stock option agreements per applicable laws. Missing paperwork can make due diligence challenging and complicated.

Not only will it cause unnecessary delays in completing the funding round, but you also risk investors backing out. Unwanted attention from regulatory agencies is another risk you run. Ensure that all documents are well-organized and easily accessible on demand.

Don’t overlook updating agreements when shareholders leave the company or sell their shares to third parties.

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Errors and Inaccuracies in Shareholder Data

As mentioned in the preceding sections, the cap table includes detailed information about all stakeholders and their respective data. It lists their names, designations and types, values, and numbers of the shares they hold. Any inaccuracies in reporting this information are another of the cap table mistakes.

For instance, different classes of shares can be preferred, common, restricted stock units, option pools, and non-qualified stock. Each of these classes confers varying rights and privileges on its holders, and segregating them is crucial. Mixing them up can lead to conflicts between stakeholders. You might also unknowingly violate agreements.

Look out for calculation and rounding errors in valuing the stock. Small errors transition into cap table mistakes that can haunt you later and have disastrous consequences for the company. Errors may result in incorrect share allocations, which is highly possible when managing multiple stakeholders.

Mistakes in calculating dilution percentages can distort the cap table overview. These can specifically occur when adding unvested stock options back into the pool. You’ll balance outdated valuations against updated valuations per current stock prices.

You should also expect human error when updating the cap table with every ownership change. Then again, large companies typically have multiple professionals managing operations, such as lawyers and accountants. Each new personnel member working on the documents can make mistakes.

Misspelling names or using variations and abbreviations can also cause significant problems when creating stock certificates. The chances of confusion and inconsistencies lead to cumbersome cancellations and the need for replacements.

How to Avoid Cap Table Mistakes That Can Haunt You Later

One of the most practical solutions for minimizing errors is to digitize your cap table. Spreadsheets are undoubtedly handy tools for logging the distribution of your stakeholders. However, as the company and its capital structure evolve, managing multiple entries introduces additional complexity.

You can’t rely on manual data entries and updating calculations as you go along. Not to mention the time and resources required to handle administrative tasks.

Don’t lose sight of the fact that an accurate and well-organized cap table influences the company’s growth and investment-securing prospects. You want to deliver a reliable snapshot of the startup’s cap structure that stands up during due diligence.

Understand the importance of the cap table and work on eliminating the red flags that can discredit it to investors. Start at ground level and build it up even as you establish the company and have it up and running.

Always view the company from the investors’ perspective, but also focus on your vision for the company. Do what it takes to transform it into reality.

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