Advice from a venture capital investor to start-ups (pt. 1)
When it comes to the Due Diligence (DD) of startups, there are many aspects and documents you need to look at as an investor. For this post, however, let’s focus on cap table, who is in the on list and how it is strucutred.
In short, the cap table is a list made up of all the names of the existing shareholders, along with:
- Stage of investment
- Stock class (common or preffered)
- Stock authorised and price paid
- Valuation at each stage and dilution over time
- Any outstanding convertible loans or SAFE notes
The cap table is important because it shows the investor (me) a number of things; who I am getting into business with and their position (influence) within the company, as well as the relative health of the company.
For example, at the seed-stage, I expect the founders to still retain the majority of shares. Should this not be the case, this is often a red flag and something to be addressed early on.
It might be that a pre-seed business angel acquired a good chunk of the business and is now not contributing to the business anymore. Former employees or founders can as well take a good amount of the company’s shares while being inactive. This can be annoying in future rounds because you always need their votes. Once they disagree, the trouble begins. One of my portfolio companies once needed, for a major strategic pivot, 100% of the votes. Because of disappointed former employees the resolution never went through, which started a painful process thereafter. The board of directors had to figure out a workaround to keep the company on track.
The problem is not that you might have too many shareholders to deal with, but how to manage them properly. One way to reduce the headache of managing too many shareholders is pooling. You can pool several shareholders below a certain ownership percentage in one group and let them be presented by a sole representative. Not every shareholder would like it, but sometimes at a certain size it’s necessary.
Another thing to address is the influence of convertible loans once they are converted. Before being too excited about the pre-money valuation, make sure you calculate the post-money valuation including all potential dilution factors. Once I saw an exciting startup. They opened up their data room to us and we started the DD. Many aspects looked fine, but when we started looking deeper into the capitalization cable, we started noticing some red flags where some convertible loans were about to be converted shortly after closing the round. The valuation cap on the loans was too low compared to the Series A valuation we would have had to accept. This means the creditors would get a large number of preferred shares without contributing new money. The deal was, in the end, less attractive.
To sum it up, always ask yourself first, do I want to be part of this group of shareholders? Can I trust the current majority shareholder? Is the capitalization table well structured? Are there mechanisms in the shareholder agreement that allow for future pooling or the like? What does all this mean for me as a potential new shareholder?
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