Part III: Is your cap table broken? Mistakes to avoid. The Startup Founder's Guide to Equity
Hi there! Welcome back to The Startup’s Guide to Equity. In this installment, we’re going to walk you through what a broken cap table looks like and how to avoid common mistakes so that your cap table doesn't become a crap table.
Imagine the following.
Your company is growing like crazy. You've built a great deck, practiced your pitch, and are ready to fundraise. Your meetings with investors go well and you're optimistic you'll raise quickly. These investors ask for your cap table, and then...crickets.
You hear nothing, and finally, get a backchannel from a close friend. The problem is your cap table. But how could this be? How could just a cap table stop you from raising?
For many founders having a cap table is an afterthought. In actuality, a cap table is a vital part of a startup's future because it determines who controls the company and who has the incentive to make it successful. In this post, we'll cover:
- What is a cap table?
- How do cap tables "break"?
- How to build a strong cap table
This is our last installment in the series. You can read the first installment here where I dive into the equity basics and the second installment here, where I cover the equity terms every founder needs to know.
What is a cap table?
The ownership of a company is recorded on a cap table. It records the stakeholders (employees, investors, and founders) and how many shares they each own. This is a basic cap table:
How do cap tables "break"?
Investors care about your cap table because ownership matters for incentives. They want to know that the right people are incentivized to stay with the company for the long term and make it successful.
Cap tables break when the wrong incentives are in place. We've seen hundreds of cap tables at Pulley, and below are common mistakes founders talk with us about. At best, these problems deter investors. At worst, they are deal-breakers to your next funding round:
- Over-dilution in the early rounds - This may be counterintuitive, but investors want you to own more of the company. Founders owning less than 10% of the equity at the seed round is a red flag. You receive more dilution at every round of funding. If you own too little of your company today, investors will worry the key decisions makers won't have an incentive to stick around in the future.
- Inactive stakeholders with dead equity - Anyone who owns more than 5% of the company at the early stage but who isn't involved with the company (i.e. a current employee or investor) raises questions. There is also the issue of fairness. Having a person who does little owns a large chunk of the business can be demotivating to all the current employees who are working hard at your company.
- Missing employee equity pool - Employees should be incentivized to contribute to the company's success through owning equity. A missing employee equity pool makes investors worried about talent. Is the company set up to attract strong talent who can put in the work to make it successful?
- Weird terms - Anti-dilution clauses for founders, dividends, super pro-rata rights, etc. are all terms that raise a second look. When investors see non-standard terms, they wonder a) What else are they missing? b) Why does it exist? Non-standard terms prolong diligence and delays closings.
How do I build a strong cap table?
Many of the major decisions around your cap table are decided early. Your first investor and first hire have a lasting impact on your impact. Here's how you can structure your cap table for success:
- Be generous with equity - We are seeing increasingly generous equity grants at the early stage because great people have many choices. Most companies set aside 10-20% of your company's equity pool for employees. You can see standards for equity grants that suit companies at your stage through services like OpenComp, Pave, or Option Impact. Give everyone the standard four-year vest and one-year cliff to protect against bad hires from walking off with too much.
- Watch your dilution - A good rule of thumb is to give away 10-20% in your seed round. You give away less equity in future rounds because your company is less risky. Raising on SAFEs can make it more complicated to model your dilution. You can find an online spreadsheet or use a cap table tool like Pulley to know exactly how much you're giving away.
- Keep it simple - Complicated cap tables cost more money in legal fees + admin time. Raise on post-money SAFEs and use options to grant equity. Use the same forms as everyone else from Atlas or Clerky or Pulley. There are standard grants for international and US-based employees that can save you time and money. These forms are well-drafted, clear, and most importantly give comfort to investors and employees during stressful raises.
The most important tip: Optimize for people.
The people on your cap table are your partners as you grow your company. Having the right partners can get you access to a network of investors and customers who can help your company succeed. Your choice of partners is everything.
Be intentional about who is on your cap table and find partners who can help you grow your company. Holly Liu, co-founder at Kabam and former YC partner, has a great post on how your cap table is a crap table when there are more "Matts on a cap table than women".
Optimize not just for the best terms, but also for people with the experience to help your company grow. I've found that former founders are the best investors. They can give you tactical advice because they've done it before. And they can help you get through the rough spots because they know what it's like to be in the trenches.
Be intentional about who you invite on your rocket ship, and build a strong team of backers who can help you succeed.
This is our last post on our guide to equity! Be thoughtful about equity, but don't let it monopolize your time. The best place to spend your energy is on building your product, hiring great teams, and delivering value to your customers. Focus on growing the size of your pie by 1000x; don't obsess over how to carve up a small pie.
As originally seen in Femstreet: https://femstreet.substack.com/p/keepingyoursliceofthepiepart3
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