When it’s time to raise capital, a cap table tells the story of the decisions management made throughout the life cycle of your company thus far. To ensure the round does not fall apart before it even gets off the ground, here are a few things you should try to avoid:
Dead Equity: Dead equity is ownership without ongoing contribution. It almost always forms early, when founders are moving too fast and either skipping or skimping on documentation, resulting in equity being granted without vesting schedules, buy back clauses, or other claw back provisions if a shareholder leaves early on bad terms. From an investor’s perspective, they fear that it will demoralize the active team, who see the non-contributors continuing to benefit for their hard work and growth, among other issues.
Promised Equity: Verbally promised, but non-papered options, warrants, and other equity grants create not only a messy picture, but signal that management is not buttoned up when it comes to corporate governance. It can also create issues with creating the pro forma, or result in an inaccurate pro forma, for the round if some equity isn’t yet on the cap table.
Already Crowded Cap Table: No doubt it’s easier to convince someone to write a $10,000 check than it is to write six figures or more, but soon, your cap table becomes bloated with lots of stakeholders. This makes it tricky to get approvals, create consensus, and can become an operational nightmare.
Early Dilution of the Founders: If the founders have offered deal terms that cause heavy early dilution, future investors fear they become a flight risk because of their now limited upside. Founders typically take a diminished salary, and if their ownership diminishes too early it can cause them to question if the venture is viable long-term.
Equity Granted Without a 409A Valuation: Granting equity below the current fair market value can trigger severe tax penalties under Internal Revenue Code 409A. If the Board of Directors can show that it relied on a valid 409A valuation at the time of each grant, it creates a safe harbor that protects from those tax penalties.
The above is not an exhaustive list of issues that can arise, but it highlights some of the most common ones that start-ups face in their first few years relating to their cap table. In most cases, preventing these issues is easier (and cheaper) than resolving them downstream, and advice from legal counsel and a tax advisor can pay immense dividends as management makes decisions that impact the cap table.
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Disclaimer: This post discusses a general legal topic, is intended to serve as informational only, and may not reflect the most current legal trends in your jurisdiction. This informational post is not intended, and should not be taken, as legal advice on any particular set of facts or circumstances. No reader should act or refrain from acting on the basis of any information presented herein without seeking the advice of counsel in the relevant jurisdiction. Archetype Legal PC expressly disclaims all liability in respect of any actions taken or not taken based on any contents of this post.
