Founder Vesting & Other Company-Killing Capitalization Problems
There’s nothing more frustrating than seeing a company with so much momentum hit a wall due to (foreseeable) capitalization issues. These issues often lurk below the surface and then ambush the company at the most inopportune times — while fundraising, selling the business, making key hires, or in a routine business decision among shareholders.
What follows are a few examples of momentum-killing capitalization issues, how they manifest, and some methods to resolve them. I’ll focus on the three most common ones I see: (1) lack of founder vesting, (2) too much founder dilution, and (3) overvaluation.
Lack of Founder Vesting
Lack of founder vesting can kill a promising startup in its early stages when a founder in a 2+ founder business leaves early, thereby taking a huge chunk of the cap table with them without a way for the company to get it back. This leaves the remaining founder(s) in a difficult situation where they continue to work for the company to achieve the same result on a per-share basis as the founder who left. This can breed resentment that in itself can kill a company.
It also creates problems for investors if they think the remaining team doesn’t have enough skin in the game due to a large “dead weight” on the cap table from the departed founder. Investors are particularly sensitive to this risk because if founders are insufficiently incentivized and ultimately leave, then the investors are the ones left holding the bag.
If not immediately fatal, lack of founder vesting combined with a founder departure hampers the company’s ability to use it’s 100 points of cap table to the greatest effect to bring on talent, thereby necessitating additional cash comp or dilutive equity grants to make up the difference.
One way to resolve the issue is a retroactive founder vesting agreement giving credit for work done, but subjecting the remaining equity to time-based vesting — similar to the vesting schedules found in most ESOPs. But this is much harder to put in place if a founder has already left the business with all of their equity and therefore has little incentive to sell it back as they won’t be vesting it due to no longer working for the company.
The reality is co-founders often leave the businesses they found. It need not be acrimonious — life or professional events happen that cause people to reevaluate their priorities and then very naturally transition out. In recognition of this possibility, it’s worth putting founder vesting in place as an insurance policy to protect the company, and by extension, the remaining value of the departed founder stock. If everyone sticks around for the duration of the vesting period (e.g. four years), then they get the full value of their equity even if they depart later.
Too Much Dilution
Continuing on the theme of thinking about company capitalization as a limited resource for incentive compensation, another potentially company-killing problem is too much dilution.
Success on a traditional hyper-growth venture path involves taking on a fair amount of dilution. At 20% dilution per round, it’s possible for founders to lose majority control of their company after a Series A if they’ve done a pre-seed, seed, and seed extension leading up to it. But while founder ownership will decline over time as investors and employees join the business, the idea is the value of the remaining founder holdings should appreciate with each successful fundraise (i.e. the proverbial smaller piece of a bigger pie).
The problem appears when the dilution and loss of control is not counterbalanced by the growing value of the company, such as when the company stumbles, pivots, or runs into an exogenous event. In these instances the expected value of a founder’s holding may be so low relative to other things they could be doing (i.e. a traditional job), that it creates a principle-agent problem for investors and shareholders similar to what can happen without founder vesting.
One solution is a recap initiated by an investor evaluating the business (if they don’t simply pass due to the complexity of it). Investors will typically ask to shift company shares away from existing investors and toward the founding team in order to keep the key operators motivated. This is not an easy thing to do as existing investors are (rightfully) protective of their equity, and can lead to difficult but necessary conversations.
A word of advice on recaps: if it’s looking like you’re going to need a recap to get your business funded and your team motivated, it is always better to do this sooner and in one fell swoop than later in multiple attempts should one recap prove insufficient. Anytime it feels like there’s a reset in the business (e.g. a pivot) is a good time to look at the capitalization and determine if it too needs a reset.
Overvaluation
Another common capitalization problem is raising capital at a high valuation and then not being able to support it or grow into it. I’ve written before about how too high of a valuation can make it difficult to raise the next round.
This hurts most when cash is running down to the point where the company needs to raise another round to stay solvent, but for various reasons the terms from the market are not attractive, or require much more time in the fundraising saddle, thereby taking time away from growing the business. A valuation disconnect is most commonly due to company underperformance, but can also be due to exogenous factors.
If investors continually pass on valuation, then it’s worth an internal conversation with existing investors and other shareholders to figure out if a flat or down round may be warranted to reset the valuation closer to the company’s performance and the market conditions in order to attract additional funding. Similar to the recap scenario described above, these can be incredibly painful discussions and can involve a lot of complex legal and structuring issues, but if resolved the company lives to fight another day.
In conclusion, a necessary condition for a fast-growing, resilient company with motivated founders and competitive talent is careful coordination and alignment of interests between founders, investors, and employees as part of the company’s overall capitalization.
This is the proverbial foundation for the company to rise. As cracks appear in the foundation, it’s critical that capitalization issues get diagnosed and addressed immediately, and not pushed aside until something collapses.
