Cap table debt — and how to refactor your shareholder base
Some of you might have heard about the concept of Technical Debt, a term coined by Ward Cunningham and extended on by Martin Fowler, that describes the “extra development work that arises when code that is easy to implement in the short run is used instead of applying the best overall solution.” I figured that this concept doesn’t only apply to coding, but also to investing and the “sourcecode” of your company ownership, the captable. In this post I want to examine the similarities and suggest solutions for refactoring.
Let’s look at the original thought first.Technical debt simply means that the decisions you make today add up in your codebase, possibly making future changes much harder, slower and thus more costly to implement. In other words: your decisions create debt that comes at a cost.
Of course there are often good reasons for taking a shortcut: when you don’t know the best possible solution, you have to do last minute changes or you have to meet a deadline for business reasons. And even though the perfect solution would be preferable, making it work is more important now. It only becomes a problem when you never repay your debt, and instead accumulate it to the point where you have to deal with it or the software breaks.
Your investment rounds can lead to cap table debt
Your investor base is actually very similar to your codebase: As a seed investor we often see companies that already did previous rounds, with Angels or FFF, first professional investors, accelerators, etc. Because of pivots, longer development times, customer development, funding reasons, etc. they already have a long list of shareholders in their cap table and have given away a significant portion of equity early on.
It’s natural that the older your company is, the more shareholders you will have in your company. However, we often see seed stage companies with 10–30 shareholders, which creates additional overhead in every step you take building your company, especially when it comes to raising more money or making important business decisions. Building on the concept of technical debt, I would call it: cap table debt.
The more shareholders on your cap table, the more cumbersome it becomes to collect signatures, get power of attorneys, inform everyone and in very crucial moments, when time matters, get feedback or decisions. Even the dynamics of board meetings change with more investors in the room. Managing that is part of the deal, but it gets worse if there are inactive shareholders on the list, if fallouts with investors happen, or if the ratio of equity held by investors versus the team is out of balance.
What type of debt to avoid
Using Martin Fowlers Technical Debt Quadrant, we can try to structure how we look at cap table debt. He differentiates between deliberate choices and inadvertent “mistakes” on the one hand, and reckless (aka dangerous) and prudent behaviour on the other hand. Below are some of the typical phrases we hear from founders in each case.
Let’s look at the behavior in each quadrant a bit more in detail:
Deliberate but reckless choices: we layer convertible notes on top of each other, we avoid priced rounds, but neglect the problems that arise from that funding structure. We raise at an inflated valuation, because we set goals for ourselves that we might not be able to reach, thereby putting ourselves in a difficult position (see this blogpost).
Deliberate and prudent choices: we know we would want different investors, but we have no other option, so let’s take that money now and try to deal with it later (through voting rights). We have to take in a strategic investor, but let’s at least get all rights of first refusal out (see this blogpost),
Inadvertent and reckless: we haven’t even looked at investors’ rights, majority thresholds for important decisions, blocking rights, etc. We never asked our investors whether they have enough money left / reserved for us to do a bridge round if needed. We didn’t agree on proper vesting and good leaver / bad leaver clauses with all founders.
Inadvertent but prudent: we have no choice but to accept that this co-founder / investor is inactive. This investor is not helpful for what we are building now, but she was useful back then.
Avoiding the reckless choices should usually be possible and common sense. Working with the other outcomes is what is possible and should be done.
How to solve it: refactoring your captable
Many of the founders we work with have gone through a cap table refactoring. They managed to “clean” up their shareholder base by reaching agreements with people on the cap table. We often help the companies to do that because we have to make sure that the company stays fundable: while the cap table is not the driving force, it’s definitely a hygiene factor that needs to be in order. For many investors broken cap tables are an easy reason to reject, as it’s an uncontestable datapoint and usually will produce headaches down the line.
We usually have five ways to deal with it:
1. Combining shareholders through trustee agreements to speed up decision making. This is a straightforward process that creates process overhead for one investor (the trustee), but can be used to ease pain. But beware, this is not a long-term solution.
2. Board or decision thresholds are a common strategy that should be considered in every company after a certain size. This transfers most of the big decisions to the board or cuts out small investors from the decision process. Better than the above, but often only an interim solution.
3. Reaching an agreement with co-founders / investors to get parts or all of their shares for part of the exit price. In most cases inactive people on the cap table will, after some discussions, agree to some form of warrant that guarantees them part of the exit proceeds. That’s better than seeing the company die, when your shares would become worthless.
4. Buying out other people from the cap table is the preferred solution of many shareholders that are affected, but most of the time those “secondaries” are hard to factor into funding rounds and usually only happen if there is massive interest, which rarely is the case if the cap table is broken. If it happens, most of the time it’s at nominal value or a severe discount to the current valuation.
5. The last resort is a downround to dilute those shareholders that can’t or won’t participate in the financing round. As this is a very hostile form of cleaning up a shareholder base it’s difficult, depends on a general agreement and leaves scars behind. It also creates legal risks in case of later exits.
No matter what way is chosen: the earlier and more vigorously this is done the better. It’s like removing a bandage: it hurts for a short time, but it’s necessary for long term healing. And it also doesn’t mean that cap table debt should never be incurred. Capital is necessary to grow your company, and sometimes a quick solution can be the right one for the moment. But it means that you have to manage your cap table just as you would manage your codebase.
By Michael Schuster, Managing Partner at Si.
Thanks to Isabel Russ and Daniel Hoffer for reviewing and improving this post.