Buyer beware: Bad cap tables will kill startups

Being in an early ecosystem we find shareholding cap tables that are not optimal at best, downright messy at worst. As a result, founders get squeezed between "dead equity" and incoming equity from new investors, killing their incentives to maximise performance for the company.

What are examples of "dead" equity we have seen?

1.    Family members and other "randoms" on the cap table

Startups will come across as unprofessional when wives, husbands, siblings and parents are on a cap table without being in the actual business. This might be a traditional practice in Bangladeshi businesses, but startups looking for professional investment should avoid this.

2.    Advisors who take excessive equity

Accelerators and incubators will often take equity in exchange for program participation, with or without direct cash investment. The equity they take might be outsized compared to their direct investment, to reflect the "in-kind" support they provide in terms of expertise and networks. Startups may also seek advisors - prominent individuals who can open doors and create opportunities for the company, or help them navigate the legal and regulatory landscape if they are in a sector that's sensitive to regulations and high-level access like fintech and govtech, or work on specific projects according to their expertise. Both advisors and accelerators may be wise to onboard onto a cap table as part of a strategy to build the team and organisational skill sets particularly in the early days, especially if said advisory shareholders have experience scaling companies in a similar field.

An issue arises when these advisory shares collectively end up taking more than 5% of the business. More importantly, when these advisory shares are not tied to on-going KPIs and are vested upfront, this is a surefire way to create resentment among founders, money paying investors and even employees who may aspire to a stock plan, post-issuance of shares.

In general, a company should seek to limit their pool of advisory shares to less than 5% of their overall cap table, and individual holdings of advisory shares to between 0.25-1% depending on the type of work expected. They should also be tied to KPIs, and vested over a period of time. The Founder's Institute has a great framework and contract template for this, called "FAST."

Sometimes, founders are so eager to onboard the right people onto a cap table and pitch deck, that they forget that ultimately advisory shareholding is a type of part-time employment and advisors have to work doubly harder than purely financial investors to earn those "free" shares.

3.    Founders who left the business

Some founders may have opportunities to go abroad for graduate degrees, or are under pressure to take a job. Though they had every intention to build the business, it became untenable for them to stay full-time. They may even try to play a part-time role as a compromise, though at that point, they are more of an advisor than a founder, and an advisory stake may be more appropriate.

Moreover, an incoming investor has to ask, should these founders who have left the venture deserve the 10, 20, 30% of a company while the full-time founders carry on? How much value is being generated for this part-time or non-existent work for such large stakes? Of course, things can be tricky if the outgoing founder had invested funds into the venture. But at that point, it is far better to treat that founder as an angel-type financial investor, and clawback any excessive shares beyond stakes taken by other financial investors. These are difficult conversations to have, but important and necessary ones.

Another tactic is to implement a vesting schedule for all founders. David Rose, the founder of New York Angels, recommends a four-year vesting schedule with a one-year "cliff," during which a founder won't be entitled to any shares if they leave. Following that, a monthly schedule for the next three years awards more shares the longer founder(s) stay. If they leave before the four, they keep whatever shares were awarded and do not get the remaining amount.

4.    Founders who are not (fully) in the business

Often, a senior partner in a founding team may have no intention to join in the business full-time, as they have their own successful venture(s) to manage. Their contribution is through reputation, capital and strategy more than the day-to-day. Or, a founder wants to join but the business and its funding and cash flows may not be able to accommodate every founder to draw a salary right away. Fast forward a couple of funding rounds, and the passive or part-time founder(s) still have not joined the business, yet they have taken significant equity at the expense of the day-to-day founder(s). Once again this is a recipe for short- and medium-term resentment, and long term disaster, as the dead equity could have been freed up for incoming shareholders, employees as well as the day-to-day founders. Books like Slicing the Pie and platforms like GUST have great platforms to figure out the founder's equity split based on money, time and responsibilities. In general, it's a red flag when passive or part-time founders have equal or more shares, individually or collectively, than the CEO and other day-to-day founders.

5.    Early angels with too much equity

This happens often in early stage ecosystems such as Bangladesh, where early investors will take way too much equity. The most egregious examples are when they take majority shares, but even 30-40% can be too much when the initial investment is below U$200K in an angel round. This is born out of a mentality that the more shares one gets for the investment, the better the deal. This may be true in an established SME-type business that will seek to generate cash flows and dividends as soon as possible, and hence there's value in maximising one's proportion of those impending cash flows. But the better deal in an early-stage startup company, when so many things including business models are uncertain, is when the investment appreciates in value in future rounds. That appreciation comes through a combination of two things - the founders' hard work in creating value for the company (through recurring and growing sales and user base, product development, IP generation) and future investors' willingness to recognise that value in the form of higher valuations when they invest in the company. Both are being jeopardised when early investors take large chunks. Founders have less incentive to work hard as their upside gets limited, while there is less for incoming investors.

In general, dilution should be kept to below 20% for pre-seed rounds. As the ecosystem matures and there is more competition for deals, that might become 10-15%, and then 5-10%. That's fine, because there should also be a corresponding increase in liquidity for follow-on rounds in the coming years.

"Honorable" mention: Too many investors and shareholders

A pre-seed stage cap table with more than five non-founder shareholders starts getting tricky. More than ten and it's highly cumbersome. How will the founders deal with achieving consensus before incoming rounds and signing collective documents such as shareholding agreements? Even the logistics of collecting signatures, when shareholders are based in different parts of the world, may delay critical compliance-related tasks. What about all the stakeholder management they have to do in communicating to such investors and keeping them on-side regarding the business and fundraising strategy? In general, less shareholders is better, though in relatively immature ecosystems like Bangladesh, where start-up and risk capital is still scarce, and special purpose vehicles and other mechanisms to consolidate investors are non-existent, it may be a necessary pain to swallow.  

One way to mitigate this is through proactive stakeholder management, including monthly emails on progress and quarterly investor calls. We have had multiple non-resident investors create joint companies and vehicles in the US that would take shares or SAFE notes in the US- or Singapore-registered entity of a Bangladeshi company. Another tactic we have experimented with is smaller shareholders in a round providing an official proxy to one of the shareholders or an advisor to sign documents on their behalf. Both are possible if the startup has an offshore entity in places like Singapore and that is where the investment is being made before it is sent to Bangladesh via the domestic entity.  For domestic entities of startups, in the longer run, BAN may have to take the route taken by our mentor networks like Indian Angels and Lankan Angels in creating a fund that consolidates smaller tickets and investors into one line item on the cap table, through direct investments from BAN's fund.  This will be the subject of future articles - the mechanics of off-shoring and the logic behind a fund model for angel investments.

If the equity has been given, what can be done?

There are really three options to fix a broken cap table where the day-to-day ("executive") founders have diluted too much. One is a voluntary clawback of the shares in question, and transferring those existing shares to either to the day-to-day founders or into an option pool for founders and employees. The second could be some kind of a new share option pool reserved for the executive founders, potentially based on strong performance or a timeline or milestones such as future fundraising, that can be issued to dilute the other shareholders for the benefit of the founders. Typically, all investors have to sign off on this in the shareholding agreement as part of a new round and it is up to the board to issue them. A third is buying out the holders of the shares in question, but that is expensive and the money is better spent being invested in the business.

Incoming investors have a role to pay here. The highest leverage they have is when they are coming into a venture. They can insist on the cap table being cleaned up before they invest in the company, as a condition of investment. After all, it will directly affect the potential future value of their investment if the cap table affects the company's ability to raise larger rounds. The carrot here for those holding the shares that need to be clawed back is that though they may own less shares, the value of their shares will go up through this incoming investment.

But an ounce of prevention is worth a pound of cure. For would-be founders, it is important to avoid these pitfalls.

Nirjhor Rahman is CEO, Bangladesh Angels