Article #8: Capitalization Table Tricky Points

In my previous article, I went through capitalization table basics. In this article, I would like to delve deeper into several critical points that should have a major effect on your investment decisions. This article is a bit longer than usual, but it was important for me to cover the important points of the cap table in one place.

 Total ownership percentage of the entrepreneurs

The motivation of entrepreneurs is one of the basic building blocks behind start-ups. The startup is comprised of a group of people who decide to make a change. Through the process, they invest years of hard work, only receiving a low salary, if any. They sacrifice their personal lives for the dream of the startup’s success and the vision of realizing future rewards. It is only fair that they be compensated upon the startup’s success. Significantly.

Fair reward for them means that they should each have 2-digit ownership percentage on the exit day. So, what does this look like on the post seed investment cap table? Using my example from Article 7, it is 25% ownership per entrepreneur, which is a good number. Why is it good? Because it anticipates the results of 2 additional funding rounds in the future, with dilution of 30% each, while keeping the entrepreneur ownership percentage above 10%.

It is a must for the investor to make this important forward-looking calculation in order to verify that the entrepreneurs’ compensation is high enough. Not doing so may result in 3 possible outcomes:

• The entrepreneur leaves and goes to a better compensating company
• He starts a new company or joins another startup with a higher ownership percentage
• The entrepreneur stays, frustrated, in the company

Entrepreneurs’ ownership distribution

Usually, when entrepreneurs establish a start-up, they distribute the equity equally. Over time, however, the balance between the entrepreneurs may differ. One of them may be considered more valuable to the company than the other. It is essential for the ownership percentage to be equivalent to the value that each entrepreneur brings to the startup’s success. This is usually a delicate matter that does not get resolved on its own.

Before investing, you may have the opportunity to influence the share distribution between the entrepreneurs. If you do so, do it gently.

How big is the ESOP?

In a startup, it is impossible to attract high quality employees using salaries as an incentive. The only material compensation that a startup can offer, is the one that is valuable upon the startup’s success - stock options. Stock options are the only material differentiator of the startup. It is essential for the ESOP to have above 10% post seed. Pay attention to timing of the option allocation. If it is after your investment, your ownership will be diluted accordingly.

Previous investment rounds

Carefully check the previous fundraising rounds. Check the price per share. If it was increased, it was an up round. Make sure the increase is justified. If it was a down round, try to understand what happened. These investment history facts will help you to validate whether the company you are investing in is correctly valued

Warrants

As was explained in my previous article, warrants can be allocated to investors. Warrants are a double-edged sword.  The positive side, is that part of the next investment round is secured. The downside, or challenge is the way the next round investors perceive it. After all, the warrant owners have a discount, which dilutes the value for next round investors. I believe that a small amount of warrants is OK. If the amount is significant, however this should be looked into.

Number of investors

Some characteristics of a startup is being fast, flexible and bold. This should be backed up with a smart and fast decision-making process. A too long investor list can challenge the nature of the startup. This is especially true if the investors are opinionated and would like to influence the company. There are ways to solve this issue by signing a proxy to the relevant decision maker or by defining the decision process in the company’s Articles of Association (AOA).

Type of investors

In addition to the entrepreneurs, the capitalization table lists all of the other investors who hold shares. Some of them you may know. Some of them, especially if they hold a significant number of shares, you must get to know. Synchronized investors is essential for the startup success.

In summary, the capitalization table is an abbreviated resume of the company. It reveals many important elements such as: relationships between entrepreneurs, past difficulties in raising money, investor attitude towards employees, balance between different types of investors and more. You just have to know how to read it. Read it carefully. Every number has a story behind it.

In my next article, I will start talking about the distribution waterfall.

To great investing!

Ido

Disclosure: I am not a professional consultant. I wrote this article myself, and it expresses my own opinions.