When your cap table makes your startup uninvestable

The CEO of a Norwegian hardware startup shared a pitch deck with me that had an unusual slide: It included the company’s capitalization table — the breakdown of who owns what part of the company. Typically, cap tables are shared in the diligence phase of investing.

Taking a closer look at the table, something significantly amiss:

Cap table

This cap table is a reproduced, accurate illustration of the cap table that was in the deck. It’s been simplified and redacted to remove the names of the investors. Image Credits: Haje Kamps/TechCrunch

The problem here is that the company has given up more than two-thirds of its equity to raise $3.3 million. With the company starting a $5 million fundraising round, that represents a serious hurdle.

TechCrunch spoke to a number of Silicon Valley investors, posing the hypothetical of whether they would invest in a founder who presented a cap table with similar dynamics as the one shown above. What we learned is that the cap table as it stands today essentially makes the company uninvestable, but that there is still hope.

Why is this such a big problem?

In less sophisticated startup ecosystems, investors can be tempted to make short-sighted decisions, such as trying to take as much as 30% of a company’s equity in a relatively small funding round. If you’re not familiar with how startups work in the long run, that can seem like a sensible goal: Isn’t it an investor’s job to get as much as they can for the money they invested? Perhaps, yes, but hidden within that dynamic is a de facto poison pill that can limit how large a startup can possibly get. At some point, a company’s founders have so little equity left, that the cost/benefit analysis of the grueling death-march that is running a startup starts shifting against them continuing to give it their all

“This cap table has one giant red flag: The investor base owns twice as much as the three founders combined do,” said Leslie Feinzaig, general partner at Graham & Walker. “I want founders to have a lot of skin in the game. The best founders have a very high earning potential — I want it to be unquestionably worth their time to keep going for many years after my investment in them … I want the incentives to be completely aligned from the get go.”

Feinzaig said that this company, as it stands, is “essentially uninvestable,” unless a new lead comes in and fixes the cap table. Of course, that, in itself, is a high-risk move that is going to take a lot of time, energy, money and lawyers.

“Fixing the cap table would mean cramming down existing investors and returning ownership to the founders,” Fainzaig said. “That is an aggressive move, and not many new investors are going to be willing to go to those lengths. If this is the next OpenAI, they have a fair shot at finding a lead who will help clean this up. But at the seed stage, it is brutally hard to stand out so clearly, let alone in the current VC market.”

With unmotivated founders, the company would potentially exit sooner than it might have otherwise. For those of us who live and breathe venture capital business models, that’s a bad sign: It leads to mediocre outcomes for startup founders, which limits the amount of angel investing they will be able to do, taking the entry-level funding out of the startup ecosystem.

Such an early exit would also limit potential upsides for the VCs. A company that exits later at a far higher valuation increases the chance of a huge, 100x fund-returning outcome from a single investment. That, in turn, means that the limited partners (i.e. the folks who invest in VC firms) see reduced returns.