Wednesday, December 21, 2005

Cap Table Hygiene

Venture capitalists are very much tabla rasa investors. One frequently hears about deals with "no hair," "plain vanilla terms," and good hygiene. Conversely, deals that come with cap table challenges (too many investors, too much prior preference, or onerous terms granted to a prior round) are often dead on arrival.

Why? My view is that company formation and growth is hard enough - one has to deal with market risk, technology risk, team risk, downstream financing risk, etc; therefore deals that layer "bad organizational/legal hygiene" as an additional risk factor into the investment evaluation tend to fail to secure investment.

In thinking of starting a company, it is worth understanding the VC industry's attraction to greenfield situations and is well worth thinking through two specific capitalization challenges that often create downstream pitfalls.

  1. Too Many Founders

A typical Series A sees the following equity ownership distribution: VC syndicate 50%, option pool 20%, founders 30%. Each subsequent financing will see founders diluted by roughly 20% per financing, such that after three rounds the founder shares represent 30%*.8^2, or 19.2% of the company. The per founder math is very simple - founder shares/# of founders. It almost seems redundant to state that too many founders can greatly impact the downstream economics of the founders, however, I have seen very smart, experienced founding teams launch with 5-6 founders and come to realize later that the per founder ownership in the entity creates real incentive problems. The VCs will rarely take less than 40-50% of a Series A and the pool is almost always 20%. Therefore it is important to think through the distribution of the remaining shares to ensure that each member of the team is truly required to get the company off the ground. Teams of 2-3 founders seem to be the norm and cap table issues, questions about equity (wrt fairness), often arise if the team gets much bigger.

2. Too Many Common Holders

All things being equal, the number of common shareholders is inversely proportional to a VC firm's interest in funding a company. The brutal reality of company formation is that often one must take capital from as many angels as necessary. While a small number of qualified angels can add needed runway and perspective, too many angels creates shareholder issues that may impact downstream financings, acquisitions, and legal liability. In raising angel money, try to limit the number of investors required to hit the financing target. When shareholder consents are required - financings, acquisitions, etc - the logistics of rapidly getting approvals can be problematic. I have seen some buyers require full shareholder consents, even if not legally necessary, in order to limit downstream problems relating to minority shareholder lawsuits.

Reality often dictates the necessity of sub-optimal strategies, however, if you can think through how many founders and how many angels to have in your next company you can limit the negative impact of "bad hygiene" on a venture financing.


  1. Anonymous1:48 PM

    Wow--remind me to flee when your firm approaches a company that I and my well meaning angel financing friends have funded.
    An angel

  2. The post does not suggest not to take angel money, nor does it indict angel investors. Far from it. In fact, most of the start-ups we fund at HWVP have taken money from angels. The challenge is if there are a score plus of angels. The more not the merrier when shareholder consents are required and the overhang of potential minority shareholder lawsuits impacts downstream financings.

  3. Anonymous4:12 AM

    I've been an angel for 6 years in the SE. I've never witnessed or heard of a minority shareholder suit against a VC firm. I'm aware of the epinions suit--that's about it. I have(and my angel investor friends) been party to uprounds, downrounds, cramdowns, washouts, bankruptcies, pay to play, you name it--and I still haven't seen a lawsuit. Have you?

  4. I found this entry after writing something similar from the entrepreneur's perspective. I had the pleasure of meeting Will a few years ago.

  5. Anonymous8:18 PM

    No matter how it is said, baked or cooked, smarter head chefs would agree too many cooks in the kitchen is a bad thing.