Managing Cap Tables and Term Sheets: Broken Cap Tables and Messy Terms

Will originally presented this topic with Corey Tisdale in a workshop for founders hosted by The Idea Village.

Cap tables play a key role in a start-up company’s overall strategy of raising money to grow its business and turn an idea into a service or a product. It is crucial for business owners to set up cap tables properly. This avoids sticky financial situations, helps companies move forward and attracts potential investors.

Cap tables are documents that typically show:

• • Who owns shares of stock as well as convertible notes and SAFEs that may convert into shares of stock.
  • How many shares each stockholder owns.
  • What classes of stock (i.e. common/preferred stock) they hold.
  • Whether shares of stock have vested or not.
  • Whether shares of stock are reserved under an equity incentive plan for issuance to employees and other service providers.

A cap table allows all stakeholders to understand where the company is from an ownership perspective. For early-stage founders, the cap table might be very simple with just a few people listed. As a company grows with new stockholders – whether employees, investors or others – the cap table can become a more complex document.

What is a broken cap table?
A broken cap table is a situation where the cap table is upside down:

• • The founders own a disproportionately low percentage of the company.
  • Instead, too much of the equity in the company is in the hands of investors, advisors, universities, incubators and others who aren't running the day-to-day business and ultimately responsible for the success of the company.

A broken cap table can create a complete roadblock for a founder’s ability to raise capital and continue to grow the company. Generally speaking, founders or other early executives or employees joining the company need to be motivated to drive its success. With a broken cap table, the management team may not be properly incentivized to continue trying to grow the company towards an exit. When making a decision to invest in one company or another, prospective investors may be more inclined to invest in the company with the cleaner cap table.

What are the causes?

• • “Dead” equity: too much equity is in the hands of passive stockholders.
  • There is no vesting schedule in the cap table (e.g. if a founder or early employee leaves the company and their shares of stock are not subject to vesting, that founder or employee could end up owning a disproportionate amount of the company relative to their contributions to its growth).
  • Fragmented cap table: a start-up has too many small investors and no clear lead.
  • Concentrated cap table: an individual investor or group of investors hold too much sway over the direction and operations of the Company.
  • Too much too soon: founders gave away too much of the company in early rounds of financing.

How do you fix a broken cap table?

To the extent possible, it is important to fix a broken cap table because otherwise, the company may struggle to grow and ultimately fail.

There are, however, things founders can do to set their company back on the right track. Tactics include:

• • Put in place a vesting plan as soon as possible for founders and employees.
  • Negotiate buy backs or renegotiate terms with advisors and universities if possible.
  • Aggregate the smaller investors together.
    • Pool voting rights.
    • Demand a minimum check size.
    • Require smaller investors to invest collectively through a special purpose vehicle.
  • Transfer shares to founders – i.e. in the event founders own too little of the company, you can create an Equity Incentive Plan and reserve additional shares for founders.
  • Secondary purchases
  • Complete recapitalization

What are best practices for managing cap tables for business owners?

• • Familiarize yourself with the cap table’s basic elements and formats.
  • Recognize the importance of executive alignment.
  • Evaluate and implement tools to help you manage it – cap table management software platforms can be very helpful.
  • Determine and delegate ownership of the cap table within your company.

Stacking SAFEs and Convertible Notes

Start-up companies can use a popular financing option — Simple Agreement for Future Equity (SAFE) round — to raise money at the early stages as they develop their business. The SAFE is an agreement between the startup and an investor. The investor gives capital to the start-up with the understanding their investment will convert into equity later, usually during a future equity financing round. The SAFE is not a debt instrument. It doesn’t accrue interest. And it doesn’t have a maturity date.

SAFE stacking describes a scenario where a startup raises capital in multiple SAFE rounds by issuing SAFEs with different valuation caps.

Stacked SAFEs can be painful for a start-up company. At each SAFE round, the founders give away a percentage of their company to raise money. This adds up and can have a deleterious effect on a company’s cap table by dramatically diluting the founders’ share of the company.

Example (Stacked SAFEs):

• • SAFE Round 1 ($500,000 raised on $5MM valuation cap) results in 10% dilution ($500,000 divided by $5M valuation cap)
  • SAFE Round 2 ($1MM raised on $10MM valuation cap) results in 10% dilution ($1MM divided by $10MM valuation cap)
  • SAFE Round 3 ($3MM raised on $15MM valuation cap) results in 20% dilution ($3MM divided by $15MM valuation cap)

Priced Series Seed Round ($4MM raised on $20MM valuation) results in 20% dilution. By the time the founders reach their Series SEED round, they’ve already sold 40% of their company to investors. At the Series SEED, they’ll sell another 20% for a massive aggregate dilution of 60%, leaving them owning only 40% of their company.

Remember, a SAFE investor’s ownership percentage does not dilute when the company raises follow-on SAFE rounds. The dilution only starts when the SAFE converts into shares of stock in a priced round.

Alternatively, if SAFE Rounds 2 and 3 were structured as price rounds, the founders could have saved upwards of 11% in dilution (i.e. total dilution of approximately 49% rather than 60%).

Note that the above examples are intended to be illustrative only and the dilution calculations are back- of-the-envelope estimates.

Term Sheets
Besides a broken cap table, term sheets are another area where founders should take some care. Terms cover ownership and control of the company, valuation, risks and protections and terms for exit or liquidation. A term sheet summarizes the terms and structure for a potential equity investment. They are expressions of intent only. They are not meant to be binding on the parties.

Who comes up with the terms for start-up companies? It’s a chicken-and-egg situation. Founders may create their own terms subject to negotiation with investors. Alternatively, a lead investor may present initial terms. Whereas investors look at term sheets every day, founders typically are less familiar. Experienced counsel can help founders negotiate term sheets and avoid traps.

There are several key terms for SAFEs and preferred stock issuances. It’s important to truly understand the implications of each, which are not always readily obvious.

 Key SAFE terms:

• • Valuation cap/no valuation
  • Discount/no discount
  • Post-money/Pre-money SAFE
  • Most favored nations
  • Pro rata rights

Key preferred stock terms:

• • Participating/non-participating
  • Liquidation preference
  • Board structure
  • Veto rights
  • Information rights
  • Preemptive rights
  • Founder vesting

Negotiating term sheets with investors

Here are some general tips when it comes to negotiating.

Keep it simple. Don’t negotiate in a vacuum. And when you are doing it, think of future fundraising. Remember that the terms matter more than the dollars. And don’t be afraid to ask stupid questions.

Please contact Will Bishop or any member of the Phelps Emerging Businesses team if you have questions or need advice or guidance.