By Fernando Berrocal

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Many startups make the early mistake of damaging their cap table; a common term for spreadsheet breakdowns of a company’s equity capitalization.  Venture capitalists (VCs) and angel investors are among the (many) funding sources that wont engage with businesses where cap table concerns exist.

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Why are damaged cap tables such an issue? The bottom line is that complicated cap tables generate dangers investors prefer to avoid. Cleaning up a dirty cap table can be very challenging, depending on how much damage has been inflicted.  With the right preparation, entrepreneurs can be well-versed in the most common cap table errors–and the various implications of such mistakes.  Essentially, this chart informs readers about who owns stock in a startup, how much they hold, applicable convertible notes, and SAFEs (which will eventually become stock). It will also tell you what kind of stock they own–and whether or not any of it has vested. 

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Most likely, a startup’s cap table will be in the form of a spreadsheet. Many entrepreneurs make the mistake of using complex excel templates–do not make this mistake.  A proper cap table includes formal business contracts, stock certificates, and other types of agreements–including details regarding ownership.  In essence, this is a chart detailing how your organization's ownership is structured. A cap table will begin with a list of 1-3 founders, and how much stock they hold. There will also be information available regarding shares that have been set aside as compensation for future employees.

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Mistake #1: Giving too much equity to advisors.

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After searching your network up and down for possible connections, you've finally secured a meeting with a renowned consultant who could definitely help your business. They like your product and team, and decide they would like to join your board of directors. They ask only for equity–around a 15% ownership stake in your business. Before you make any decisions, contemplate the following items:

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• Any type of advisor with a double-digit ownership stake is above the market.
• This person is not a co-founder, a member of your team, or a manager. They're a business mentor.  No matter how recognized they are, they don't deserve as much stake as the people who have built the organization itself. 
• Another issue: they’re probably not putting 100% into your business. They're in great demand as a renowned adviser. Do you have any idea how many other firms they advise? What is at stake in the success of other firms–or their own?

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A 10-15% ownership may be reasonable if you're the only entrepreneur they're coaching. Again, however, you must consider the value of the counsel you're receiving–and the bigger implications of forking over so much equity.  Advisors with an oversized cap table percentage is a warning sign for most VCs.  It demonstrates that you have no idea what you're doing, due to the fact that double digits are totally out of line with what most advisers receive. Most significantly, it indicates future problems. In the event that shareholders vote on a matter, having 10-15% ownership held by someone without a direct investment might cause problems.

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Mistake #2: Founders with no vesting plans (dead equity).

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When founders’ shares don’t have vesting schedules, you run the risk of developing dead equity on your cap table. This term describes an ownership stake that continues to be held by an individual who no longer has a vested interest in your firm. That equity isn't doing any work, and certainly isn't motivating anyone. Tracking these individuals might be a nightmare in the event that you need to pursue any kind of shareholder agreement or vote. Furthermore, it makes investors nervous.  They don’t know how a “dead” stockholder will respond to investments–or if they will cause trouble.

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Co-founders who leave the business and take their shares are a key source of dead equity. Even if you manage to separate on good terms, having an outside individual with double-digit equity presents a negative image to future investors. So, how do founders prevent dead equity? A vesting schedule is the simplest approach.  The specific details will vary from startup to startup, but many entrepreneurs choose to mandate that founders must stay for at least one year following incorporation before receiving any equity; another common stipulation is the graduated issuing of stock over a four year period (in other words: they will not receive their complete share until four years has passed.)

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Mistake #3: Too Much was sold too soon.

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When reports of enormous investment rounds dominate the news, it's easy to be concerned with raising as much money as possible. If you submit to this temptation, you may find yourself in hot water. To start, you don't have much power when your business and products are still young.  There's no data you can present at an investor meeting that concretely demonstrates that you're ready to grab a portion of the market and take off.

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As a result, when dealing with large sums of money, you're more likely to accept their conditions rather than negotiate your own. Too frequently, this entails handing over a substantial portion of your firm. Aiming high during early fundraising rounds might generate complications aside from the possibility of losing control of your business. A high value early on may come back to hurt you if your business doesn't expand as rapidly as planned–if you run into problems along the road, you may have to raise another round at a lower valuation.

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Mistake #4: Failure to keep track of incentive stock options and non-qualified stock options (ISOs and NSOs).

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Offering stock options to new workers can help you recruit top talent sooner, but you must understand the distinctions between Incentive and Non-Qualified Stock Options (NSOs). In general, “Incentive Stock Options” (ISOs) are taxed when they are sold (rather than when they are exercised). They are taxed at the current capital gains.

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The difference between the grant and the exercise price is taxed for NSO stockholders. This tax is deducted from their regular income and is triggered when they activate the option. Stockholders must not only reserve income tax at the time of exercise, but they must also set aside 7.65% in payroll taxes. Because of how they are taxed, ISOs are better for stockholders. However, ISOs have limitations. For the financial year, you can only be taxed on up to $100,000 in ISOs; everything beyond that is taxed as NSOs.

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Mistake #5: During high-resolution fundraising, over-dilution occurs.

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During seed and pre-seed rounds, high-resolution fundraising offering multiple conditions for convertible notes and SAFEs to persuade early and help investors to get in provides a lot of flexibility. However, keeping track of the potentially large number of distinct valuation cap and discount combinations - as well as the differences in pre-and post-money valuation - could pose a potential nightmare.

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If you don't use advanced cap table software, you run the danger of underestimating how much your shares will be diluted. When all is said and done, you may end up owning less of your firm than you intended. The simplest method to avoid this?  Ensure that you have a good cap table solution in place that allows you to view - in real time - how different conditions will influence your organization's ownership  This way, you can focus on raising cash in the present–without causing difficulties later on.

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Ready to bring your startup to the next level? Apply to MassLight’s next batch. MassLight supplies capital and a dedicated tech team. We take equity in return. Have questions? Refer to our FAQ page. 

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