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Compromised Cap Tables Create Consequences
How you should think about protecting your life's work
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Every founder should be told to protect their equity like it's their life. But so many founders are incredibly misinformed and accept terms that are not in their favour at the Pre-Seed and Seed stages, which results in huge detrimental impacts later down the road.
In the current market climate, down rounds are everywhere and investors are out looking for opportunities to increase their ownership stakes and protect their own downside risk.
In my last article, we talked about the expectations large VC funds need to place on their portfolio companies to make the fund's economics work. In this article, I'll be breaking down the other side of the arrangement, namely, how founders have been affected, and how they should be thinking about future capital raises and protecting their equity.
The Ideal Equity Path
If you're a founder who wants to go down the venture-funded route, this will be one of the hardest things you'll do in your life. You've got a large opportunity that you think is there to be taken, however, it comes at a price and that's your equity.
To capture this opportunity, you need to raise money in exchange for equity in your startup. Unfortunately, the fundraising process is incredibly bespoke and is largely reliant on your business' performance, your own network, skillset and pedigree as well as the market that you are operating in. Some founders will need to give up more equity than others in an effort to achieve their dream outcome.
In the example below, we are using a base assumption of 20% dilution per round. That is, you, are giving investors 20% of the equity in your company in exchange for however much money you can raise at each time. At the pre-seed and seed stage, this might be a few hundred thousand to a couple of million dollars, and at the Series C+ stage, this might be hundreds of millions of dollars.
This is probably the ideal case for any founder. 20% dilution is the industry standard for early rounds, and whilst it might go lower (around 10-15%) in later rounds, it’s hard to predict when that might happen.
Again, in an ideal world, your startup's valuation is increasing at every round. In the example below, I've mocked up a valuation pathway that is reliant on a 3x uplift on every round. I've also laid out how much the founder would own in both percentage and dollar terms. For example at Series A, the founder holds 51.2% of the company, valued at $23.04M. At Series D, this decreases to 26.2% of the company, valued at $318.50M.
As you can see, the goal is to limit the amount of equity you give up, whilst also maximising the valuation of the company. And this is what happened in 2021. Founders were able to give up 10% of their company, and receive incredibly high valuations which is fine in a bull market where there are willing investors to keep marking up investments, however, what happens in a bear market?
Bear Market Vibes
In a bear market, valuations are more cautious, rather than optimistic and as such are tied to cold, hard numbers, rather than whimsical dreams and visions.
In the example above, we start off quite similar to the ideal path, however, get derailed within a few years and require a down round (at 10% dilution) to raise bridging capital to get to a Series A. From here, we have two strong funding rounds, before another down round (at 10% dilution) before the Series C. Ultimately, the effect of extra dilution is apparent at Series D, where the bear market founder has 21.2% ownership, whereas, in the ideal scenario, the founder has 26.2% ownership. As the company grows in valuation this will have an increasingly large impact on the value of their holding.
To drill down further into the dynamics of an individual round, let me take you through an example: Imagine a company that raises a $5M seed round at a $25M Post-Money valuation because the founder was told to take 20% dilution. At the time they might've had $300K in revenue, representing an 83x multiple. I wish I was joking, but these rounds were quite common in 2021.
Now, over the last 2 years, this company has managed to 8x revenue to $2.4M and is looking to raise $10M. Again, the founder wants to take on 20% dilution, which would represent a $50M valuation or a 2x uplift on the Seed round.
However, when fundraising, VCs reject this proposal and instead issue a term sheet for a $24M valuation, based on a 10x revenue multiple. This, the VCs argue is a generous offer, given the average SaaS revenue multiple in public markets is ~7.8x as per Bessemer's EMCLOUD NASDAQ index.
So despite growing revenue a substantial amount (8x!), this startup still needs to take a down round in order to raise money and survive. We're in a predicament when top-quality companies need to take down rounds.
Whilst this might be a semi-extreme example, and I expect startups growing 8x to be able to command slightly higher valuations, it's not far from the truth.
As a VC, I'm seeing numerous startups who raised at high valuations in 2021, become crushed at the next round because they haven't grown fast enough, or aren't making enough revenue to justify a high revenue multiple.
Moreover, with a down round, depending on the legal terms of prior rounds, certain share classes may have anti-dilution protocols built in which protect existing investors from taking on further dilution. This means that only the founders and employees - the people actually doing the hard work - take on the brunt of the stress in this scenario.
So, herein lies the importance of valuation discipline from the founder's perspective. I completely understand the temptation and appeal of raising at a high valuation. It makes you feel like you're worth something substantial, but the potential detrimental impacts it can have on your business culture and morale are not worth taking.
Misaligned cap tables
We've covered founder ownership and the dangers of over-diluting, now let's uncover the rest of the cap table.
Outside of the founder, external investors will end up holding the next highest amounts of equity in the startup. As the startup nears IPO, there is a strong chance that these investors might even hold more than the founder.
In any case, choosing who actually goes on your cap table deserves more scrutiny than what is given today. In the bull run, founders were told to be selective with who goes on their cap table, but most ended up choosing the highest valuation offer, or the most capital. Now, the common advice is any money is better than no money.
But is it really? What happens if you inadvertently accept really bad terms or accept capital from an investor who really doesn't understand venture capital?
It creates headaches and a lot of them.
I think it's pretty clear what happens if founders accept unfavourable terms. As an example of a bad legal term, liquidation preferences might be incredibly harsh (2x+) and as such, founders might not see any money despite going through a gruelling process of building their business.
While that's bad, at least with some legal advice you can guard against accepting such terms. What you might not be able to guard against is a misaligned cap table.
As covered in my last article, each fund has its own strategy and return targets. As a refresher, every VC makes investments that can hopefully return its fund at least once, if not more times. For large funds, the return hurdle is higher, meaning that the company needs to be larger in size to return the fund. For smaller funds, the return threshold is obviously lower.
Immediately this creates some misalignment if you had both a small and a large fund on your cap table earlier on in the journey. The large fund will likely push you to grow fast and quickly and be more audacious with what you do. For example, a large fund might give you the license to spend cash freely and without worrying about capital efficiency only to pull that out as a reason to not invest in the next round due to concerns around spending discipline.
The small fund on the other hand might give you advice that leads to a more guaranteed outcome because they don't need you to push your startup to the brink for a good exit outcome for themselves.
Whilst I’m not saying you shouldn’t have both large and smaller funds on your cap table, it’s important to understand their incentives and the lens through which they view your company. From here, you can appropriately take or neglect their feedback, advice or direction.
Alternatively, some startups might have two similar-sized funds on their cap table, however, with ownership stakes that are on opposite ends of the spectrum. Again, the return threshold for either fund will be different and so when listening to their advice and feedback, founders need to be aware of this factor.
This will also influence commercial decisions that are placed in front of all shareholders. In the event of an early exit, the fund with a lower return target might be willing to push this through, whereas it might not be a significant enough payoff for a larger fund and so they might block the exit, causing a huge headache for everyone on the cap table, but most importantly for the founder and the startup.
More recently, Corporate Venture Capital Funds (CVC) have started becoming more prominent as a way for old incumbents to either reinvigorate their own businesses through synergistic benefits or gain access to large returns. In any case, CVCs add another complexity to the mix. They have their own internal agendas/politics, and what they promise pre-investment might not eventuate post-investment. Again, when dealing with CVCs, it's important to understand their strategic incentives and return targets to see whether they are the right investor for your startup.
Understanding your cap table is all about understanding the incentives that drive and influence different behaviours. The three things that every founder should do before taking on new investors in their cap table are the following:
Intimately understand the fund’s characteristics and return drivers. The maths on returning a fund should be fairly straightforward and the VC should be able to tell you what type of return outcome they need to return their fund.
Unpack their portfolio companies, how much these companies have been funded, their trajectories and any exits that have happened and how successful these were both from the founder’s perspective and the VCs perspective
Talk to old and existing portfolio companies about their experience with the VC. Founders tend to be quite transparent with other founders and will tell you the truth about how a VC operates and interacts with its portfolio companies and the quality of their engagement.
Whilst you can do a lot more due diligence on the VC than these three steps, this should serve as the absolute baseline for what you should do before you accept an investor onto your cap table.
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