An out-of-balance cap table will ultimately affect the incentives of founders and the long-term prospects of a business.
By Keith Benson, Director at Dow Schofield Watts Angels (firstname.lastname@example.org).
At Dow Schofield Watts, we advise our corporate finance clients on raising venture capital and use our investors’ (and our own) money to fund early-stage businesses through the DSW Angels network. One very common issue we encounter both as an adviser and investor is out-of-balance cap tables (the equity split) – where the external investors have disproportionate equity share relative to the founders. This situation can present a business with significant challenges when looking to raise investment from later-stage investors and, if not remedied, can ultimately affect long-term shareholder value.
What causes an out-of-balance cap table?
It is rare that the path runs smooth in the early stages of any new venture. Finding the elusive product-market fit together with lengthy and unpredictable development projects alongside the need to pay the bills means that cash-flow issues are common in the early days. Entrepreneurs without access to their own capital inevitably turn to private investors to give their business breathing space. This lifeline can come at a significant price.
A good experienced investor will drive a hard bargain – they are putting cash into a very high-risk venture. For a founder in distress, a relatively small share of something is preferable to losing their entire business – an extremely weak negotiating position. Even absent a distressed situation, the weight of much needed capital commonly exceeds the sweat of the founders who are responsible for the idea and the ultimate success of the venture.
We have had many founders sheepishly talking us through their cap table, having ostensibly given away much of their holding for relatively small amounts when compared to current pricing. This is usually a result of the limited options available and reflected the risk of the investment at the time. However, such a situation presents its own set of risks to investors.
What is the effect of an out-of-balance cap table?
Deal-regret by founders is common once the business is back on track and the pre-deal circumstances are forgotten. Ultimately, a disenfranchised founder will not be as effective as one who is properly incentivised to grow the business and maximise shareholder value. We all need a reason to get out of bed in the morning; further bumps in the road may very quickly limit those reasons for founders – at a time when the business most needs highly motivated management.
Further, disenfranchised founders have a strong incentive to resist any further dilution caused by the raising of further capital. A slow death at the hands of well-financed institutionally-backed competitors therefore becomes a significant risk. Any rights to enforce the raising of funds offers limited protection – a fund-raising process without fully motivated and enthused founders is virtually impossible.
Even where founders agree to raise further capital, valuation expectations will be driven by minimising dilution. An artificially high valuation expectation will lead to high investor attrition when marketing a funding round – even from an otherwise investable proposition.
Moreover, an out-of-balance cap table renders investment highly unattractive. Fundamental to any investment proposition for an experienced investor is having a management team who have something to lose – and a lot to gain! Having a cap table dominated by those making limited contribution to future success is not an investable proposition, regardless of the history of the venture.
So, what can be done?
In such circumstances, the options for shareholders are to continue without investment, find an investor who would be happy to fund a business without properly enfranchised management or accept that the cap table should be reorganised.
The mechanisms for achieving a rebalancing will depend on specific circumstances and it is essential that tax implications for all parties involved is considered. We have encountered this situation many times as both an adviser and investor and have used share transfers, company share buy-backs and substantial management option schemes in the past.
Every deal where there is an out-of-balance cap table presents a unique challenge – fixing the issue requires creativity, diplomacy and, crucially, pragmatism on the part of seed investors to give the venture the best chance of being successful and ultimately maximising value for all shareholders.
Founders and investors share a common goal in making a success of their business. So long as they are respectful of each other’s contribution, and are prepared to compromise, we can help craft a deal that ultimately improves everyone’s position.
Keith Benson is a corporate finance adviser with Dow Schofield Watts Corporate Finance and co-runs the DSW Angel network.