VC Series — Understanding your CAP Table
Understanding your CAP Table
As a VC and angel investor in MENA, I have noticed one common mistake most early-stage founders still make: they give up too much ownership of their business before they even reach Series A stage funding. From the deals I looked at since 2017, I can tell you 1 in every 5 companies had a problem with their shareholding structure. The founders in the region (and especially in the nascent ecosystem countries) seem to underestimate the importance of prudent shareholding structure to an alarming extent. Inexperience on both the founder and investor side — is at the root of this problem.
Most founders are first-time entrepreneurs in MENA and many of them have to rely on angels for seed capital. Sometimes they lose sight of the consequences of giving up significant ownership in the business as they focus on simply getting some funding.
Investors are often not experienced with early-stage companies. They become blindly focused on maximizing their absolute percentage of ownership early on rather than trying to help the founder maximize the valuation when the institutional investors come on board.
I want to share the 3 common mistakes I found in many companies’ CAP Table:
1. Founders give up too much equity at angel/ seed round
2. Founder’s shares do not vest
3. There are no stock options
1. In all the skewed shareholding structures that I saw, the founder owned too little equity at an early seed stage. While you don’t necessarily need to own 100% of the equity but you need to have at least 75–90% as you head into the first round of funding. An illustration of what the CAP table looked like for one company I evaluated in 2019:
In the above instance, the founder would literally own almost nothing at the time of exit. What is the motivation for the founder(s) to continue working for this company? How would future investors look at such a situation? Does it impact future fundraising?
The investors (and mostly angels) are also to blame for this as they demand a high equity percentage in a company. My advice: If an investor asks for a high equity stake, DON’T TAKE THE MONEY.
2. Any startup that wants to build a successful enterprise should vest its equity over time, particularly for founders and key employees. A carefully thought out and deliberate vesting schedule can prevent difficult conversations with investors or, worse, lost equity in the hands of leaving team members.
Many companies that I have evaluated did not have vesting of shares. It is a very important consideration for a startup as it addresses 3 main issues — 1) keeping the founders enthusiastic and motivated, 2) whenever a co-founder decides to leave, his unvested shares can be used to give other incoming co-founder & 3) investors and other stakeholders see it as a sign of commitment (the founders want to get their due share only after achieving something).
Note: The legal aspect of vesting varies significantly from country to country. So, contacting a lawyer to make a consultation is generally a good idea.
3. Stock Options plans are as important as vesting because, in every startup, you will have to hire some key members apart from co-founders. These key members have to be very high caliber and as a startup, you seldom can match their industry standard salary. So, the only way a startup can attract this talent is through stock options (also vested over time). Ideally, a startup should have a minimum of 10% stock option in their CAP table before the first round of funding.
I believe the ideal progression in the case of most startups would be something like this. This is just a general example and in no way represents 100% of the actual scenario a startup would go through but gives you an idea of how founders should distribute equity in their company over a period of time.
Lastly, I would love to advise early-stage founders if they are raising their angel or seed round on how to structure the round and how to position their start-ups in front of angel investors as there is seldom any traction or a solid product (MVP) to show for it at an early stage of your start-up.