A while ago I met with a startup I really liked. The team included two impressive founders, one in charge of business and product, with the other heading software development. The market opportunity seemed big, with a good product offering and strong technology foundations.
At the end of our first or second meeting, I popped a standard question: “what does the cap table looks like?”. In VC jargon this stands for how the startup’s equity is divided. To my surprise, I learned that the two founders I met only owned 50% of the startup, with the other 50% allocated to people I have never met with no future contribution to the startup’s success. This was an extreme example of what we call dead equity, ending our investment process.
The cap table may seem an unimportant detail to founders who spend their nights working on their product while chasing investors in the daytime. But early mistakes here can make a startup un-fundable as in the above example, and continue to haunt it for a long time.
The cap table is key since it determines who enjoys the fruits of success. Any change to it has legal and tax implications, but more importantly, it is very difficult to get people to waive allocated or promised equity.
The guiding principle is that equity should only be in the hands of those who contribute to the startup’s long-term success. They include full-time team members, investors (preferably value-added ones), and possibly key advisers.
A few ground rules can help founders avoid costly mistakes before raising their first funding round, and build foundations for a healthy startup:
Full-time founders should be the only significant equity holders (say above 5%). Rare exceptions could be a researcher bringing significant IP or a senior industry expert bringing access to key customers. The split between the full-time founders may or may not be equal, depending on time of joining, seniority and personal risk (e.g. leaving a paying job before getting funded). That said, one founder holding 80% with 20% split between three others is usually a bad start that will create problems at a later stage.
Don’t pay with equity. It’s tempting and sometimes equity is the only currency available. But allocating significant equity to a developer who will disappear after a few months’ work is usually a bad move for both parties. A better solution would be contingent payment once the startup gets funded, and equity only if the developer joins full-time.
Vesting is critical. Never allocate equity (even to founders who are close friends) without reverse vesting. This can be through a founders’ agreement (a very good practice) or even an email message distributed to all founders. Reverse vesting means that a person who receives equity must stay with the startup for the long-run or lose all/most of his equity. A good vesting period is four years.
Cliff is good practice. Founding a startup is never easy, and many founders leave after a while (especially after seeing that fundraising takes longer than expected). The cliff requires a founder to stay for a significant period (typically one year) in order to have any equity.
Proxy simplifies future decision making. Proxy means assigning someone to act on a person’s behalf as a shareholder in the company. This includes voting in shareholder meetings and receiving information from the company. A startup may need to receive shareholder consent to decisions a few times each year, and in some instances like funding rounds and exit, having close to 100% support is critical. The solution is insisting that small shareholders (even founders with a few percent), founders who leave the company and advisors to give an irrevocable proxy to the CEO. A formal proxy drafted by a lawyer is best, but an email exchange is better than nothing.