Strangling yourself with a cap table

At Nordic Makers we see more and more startups going into their seed round with active founders already being heavily diluted. Owning as little as 70% or less can drastically reduce the chances of raising a proper seed round. The company may suffocate unless the cap table is fixed.

Why does it happen?

Typically, the company has been growing slowly for a while and made several rounds already, but still isn’t ready for a series A round. Alternatively, a co-founder has left but there was no vesting agreement in place. A third possibility is that FFF or pre-seed investors have negotiated too aggressively in previous rounds.

Wait, is that really a problem? 🤔

Assuming that you’re building a startup that will need several rounds of financing down the road, you’ll be heavily diluted. If a founder wakes up one morning with a small stake, that’s a major risk for the investors. You leaving is one of the worst things that can happen since the investors primarily invested in you, not your product or vision.

Every startup faces inevitable dark periods. If key people are too diluted, they’re more likely to leave for a high-paid job, a big upside in another startup or even starting something new, when things turn sour.

While you’re busy pitching the investors in front of you, they’re pondering what you’ll look like in front of the next investor down the line. Seed investors think about how to sell you to A round VCs, who will think about the B round. And so on.

What’s in it for me?

The obvious financial upside aside, there are a few other reasons why retaining most shares yourselves is a good idea: you have more votes to push your views and you have a cushion if you need a bridge round later on. Also, it makes it less likely that investors with many votes can push you out if things go south.

Yeah yeah, how much should we own then?

There are of course no simple rules. For a research-heavy or hardware-focused company, you will probably have to accept more dilution in the first rounds than light-weight software companies. If there has been a change in management, old founders may still own some shares.

Despite all the caveats and exceptions, I’d like to propose a very rough rule of thumb:

The active team should own 50% after series A.

Applying this benchmark has consequences. If you’re raising a seed round that can take you straight to an A round, and you estimate 20% dilution in each round, you need to own at least 79% of the shares before the seed round. Given 25% dilution per round, you must control 89% of the company before raising seed money. And that’s assuming that no bridge financing is needed before your series A.

No worries, my active chairman owns 25%

You can really only rely on key people who commit to spend the coming 5–7 years building the company. Investors can’t bet on the full engagement from part-timers, active board members or founders who say they want to be active in the future. Only full-timers who are willing to commit for several years (e.g. through vesting) count.

Hey, that’s not fair to the old investors

You’re probably right. In many cases, the passive shareholders have earned their equity. It may be unfair to push for a redistribution. However, the 50% rule of thumb is not aiming at creating fairness. And let me be very clear: Not all companies should redistribute equity just to please investors. The purpose is just to give an indication of what most companies should expect to hear in future discussions with VC.

Of course, investors always make an overall assessment of your company. There are examples of great companies being built with the team owning as little as 20% already in the early rounds. Hopefully you score very high on most other parameters (team, traction, market size etc.) and then investors will accept a somewhat unsatisfactory cap table. But that’s an unnecessary risk to take if you can avoid it.

What if we’re already diluted too much? 😱

Then you’re screwed. No, just kidding. There are ways to fix it, but no silver bullet. All solutions will require tough discussions and hard decisions. And they can never be forced upon by an external party; you have to take the lead yourself in fixing your cap table. Here are a few ideas that might work in some cases:

  • If you have passive co-founders, they can return (most of) their equity to the active shareholders (a.k.a. vesting). That’s basically the same thing as buying shares from them for a low price. It’s better for them to have a small piece of a big pie, than nothing.
  • Create a bigger-than-normal ESOP and direct the surplus to the founders. I’ve seen pre-seed option pools of up to 30% to compensate founders for the dilution. Here’s how to do it in Sweden. This naturally requires approval from all major shareholders, including existing investors.
  • Ask your passive shareholders if they, in their own best interest, can accept to sell some shares cheaply to the new investor, so the new investor can accept a higher price per newly issued share and cause lower dilution.
  • If you have hyper-growth or other amazing traction, skip the seed round and go directly for an A round.
  • Don’t fix it. It’s your choice. It might work well to build your company in a different way. Perhaps you won’t need VC money at all or the VCs will accept the situation. Maybe it would just be too unfair to the passive shareholders to make a major redistribution. Just be aware of the risk you’re taking by not dealing with this issue early on.

Alright, we’ll fix that after series A

Oh no, it will never be easier to deal with your problems than now. If it’s hard now, imagine what it will be like when the stakes are higher and valuation goes up!

Summary

Make sure to plan your dilution early. Have the discussion with your co-founders and set up vesting. Assume that you’ll need bridge funding. Negotiate a new option pool in every major financing round. And make sure to kick ass so you can get a decent valuation in next round.

If you already own too little, solve it now or forever hold your peace. But then your VC marriage may not happen.