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Cap tables and why many early-stage startups mess them up
Entrepreneurship / 29 August 2023
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Director of Entrepreneurship
Ram connects growing companies with strategic partners. He is a serial entrepreneur and business angel with over 20 years of international experience in finance and general management. Ram has coached hundreds of start-ups throughout his career. He learned from his pro-surfing career the importance of surrounding himself with passionate people and being in the right place at the right time. Ram has excellent network contacts in Tel Aviv, Israel's tech community hotspot.

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A cap table, or capitalisation table, is a spreadsheet that details the equity ownership in a startup. Understanding a startup’s cap table is not just essential for startup founders but also very important for investors, employees and other stakeholders. Despite its significance, it is surprising how many early-stage startups tend to mess this up, leading to potential complications down the road.

Inexperience and misunderstanding

For many first-time founders, managing a cap table can be an unfamiliar and daunting task. Startup founders typically excel in product development and market identification but might lack the necessary financial acumen. Cap table management requires understanding terms like pre-money and post-money valuation, dilution, convertible notes and stock options. Any misinterpretation or miscalculation can lead to an inaccurate cap table, creating issues when raising further capital or during exit scenarios.

Not accounting for future rounds

In the early stages, it is easy for founders to overlook future funding rounds. However, every funding round dilutes the equity of existing shareholders, including the founders. An improperly maintained cap table can misrepresent ownership percentages, causing unnecessary confusion during subsequent rounds.

I personally have seen several instances where founders trying to raise a second round of investment found it difficult because they have been too diluted for venture capital firms (“VCs”) to be interested. As a general rule of thumb, the founding team should retain at least 70% of the startup before reaching Series A – usually the second or third investment round where VCs get involved.

Maintaining sufficient equity is crucial for founders to stay motivated and committed to their startup’s success. Founders who retain a substantial equity stake have a vested interest in the company’s growth and profitability.

Convertible Notes

In a prior blog post, I delved into the subject of convertible notes, a financing instrument frequently employed during the initial funding stages of a startup. These convertible notes typically transform into equity when the subsequent round of equity financing occurs. It is crucial to monitor these convertible notes closely as they lead to dilution of the founders’ equity. Their impact can sneak up unexpectedly if not diligently tracked.

Mitigating the mess

A messy cap table with too many shareholders can present numerous challenges and potential issues for a startup. With a large number of shareholders, decision-making can become complicated and slow, as it may require obtaining consent from many parties, depending on the company’s structure and the rights attached to different share classes.

Additionally, potential investors may be deterred by a messy cap table. They may perceive it as a sign of poor management or a red flag indicating potential future disputes. It can also make subsequent rounds of financing more difficult to negotiate, as new investors may demand certain ownership percentages that are challenging to achieve without excessively diluting the equity of current shareholders. Thus, maintaining a clean, simple cap table with a manageable number of shareholders is advisable for any startup.

Conclusion

Managing the cap table correctly from the outset is imperative for any startup. An accurate cap table not only provides transparency to current stakeholders but also attracts potential investors by showcasing the startup’s professionalism and readiness for future growth. As with many aspects of building a startup, the key is acknowledging what you do not know, learning quickly and getting the help you need to navigate complex waters. A well-managed cap table is a testament to a well-managed company. Do not let it be your startup’s undoing!

If you are an FS student interested in exploring entrepreneurship and developing your own business ideas, we recommend visiting the Entrepreneurship Centre. The centre offers a range of resources and support to help you get started on your entrepreneurial journey.

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