Avoiding Unnecessary Founder Dilution & Staying Out of Cap Table Trouble
by Aaron Holiday
Recently, there has been a pattern of founders raising multiple note rounds before Series A that result in upside down cap tables. An upside down cap table occurs when investors (in aggregate) own more of a startup than the management team and its employees.
Example Upside-Down Cap Table:
After speaking with founders, we heard several stories that explain why this is happening; however, there was one recurring reason: many founders are not fully aware of the impact of raising multiple notes ahead of a Series A, and they unknowingly dilute themselves much more than they desire. These founders are being caught off guard as notes mature and other notes convert to equity during the next priced round (i.e. often times at the Series A).
Over the last several years, there have been several structural changes in the seed stage fundraising landscape. In particular, because of the proliferation of seed funding sources and the fragmentation of seed into accelerator capital plus pre-seed, seed and post-seed funding, these initial rounds rounds are often the most expensive capital that founders are accepting. The increased dilution at the first institutional seed round is primarily due to larger round sizes for startups with very little traction, driven by multi-stage funds desiring to write large checks combined with the rise of micro VCs that are writing checks less than $1 million. These factors are resulting in heavy compounding dilution on future cap tables, a situation that is very difficult to reverse once a deal is closed.
In some cases, we are seeing initial rounds “priced for perfection”; essentially, significant ownership given away to investors at valuations so high that the founders have to exceed all key performance metrics with high accuracy to avoid down rounds or multiple unfavorable bridge rounds. This approach to fundraising goes against core principles of early-stage innovation and entrepreneurship, which is typically a time when a company should be encouraged to take high risk in product experimentation to find product/market fit that supports a business model ready for scale.
Additionally, the advice and sense of urgency from VCs to close rounds quickly is motivated by there being too much capital chasing too few deals. This is good for founders in that it provides them with more options for capital, as well as better valuations. However, often these rounds are moving so fast that founders do not have ample time to think through the deal terms or evaluate the downstream implications that the round will have on the company’s cap table.
The most common pitfalls of these rushed decisions and expensive rounds are upside down cap tables and pro-rata rights that constrain future Series A investors’ allocations. This is the current state of the seed stage market and we suspect it will likely to continue. As a result, we are releasing software tools for founders to quickly evaluate the downstream impact of their seed stage round decisions. These tools will aid founders in setting round terms and determining who might be the best VC partners. These tools will empower founders to make smart and fast decisions with a higher degree of confidence.
The first tool is the Cap Table Simulator. The simulator helps founders evaluate the impact of any number of notes (i.e. SAFEs or convertible notes) or priced rounds on their cap table by the time of the Series A round size closing. The Cap Table Simulator answers three fundamental questions for founders:
- Will the management company and its employees own more than 50% of the company’s equity after the Series A round?
- How much round allocation is available for new investors in the Series A round?
- What is the impact on the cap table for each additional round before Series A?
The Cap Table Simulator is the first of several tools we will release in our Founder Tool Kit.
This Multi-Note Calculator was regression tested by lawyers, founders, and VCs to ensure accuracy.