Hey friend,

Last week, I talked about that is a messy cap table and how that becomes uninvestable for the investors. We also touched how to avoid the common pitfalls.

Today, as promised, is the second part of the same topic. How to fix a messed up cap table, potential challenges to look out for, and why this is not the end of the world but its a very tough world.

Heres a step by step guide to fix such cap tables.

Understanding the current situation

First, look at the cap table and figure out who owns what shares and if there are any special conditions attached to those shares. Also check out for how much equity the founders own (or will own) post Series A (keeping in mind the per round dilution you can easily asses that).

Here’s a great guide put together by Ace Alternatives to figure out the health of your cap table.

The guide:

• Green: Displays the ideal scenario/ what most VCs aspire to see.
• Light Green: Considered acceptable - while not perfect, many VCs might still be open to discussions.
• Yellow: Starts to get tricky - Startups might need to consider adjustments.
• RED: Broken! This is a glaring red flag for the majority of VCs, necessitating immediate corrective action.

Once done you need to start with communicating to the shareholders that includes (ex founders, angels, accelerators/incubators, etc).

Strategies to fix the cap table

1. Transferring Shares to the Founders:
   1. Benefits for Founders: By enlarging the ESOP pool, some of these new shares can be allocated to the founders or the management team. This ensures that they maintain or increase their ownership stake, keeping them highly motivated and invested in the company’s success.Dealing with Dormant Shareholders:Engaging Early Investors:
      • Buybacks: Offer to purchase their shares back. This reduces the number of shareholders and can consolidate ownership.
      • Secondaries: Facilitate the sale of their shares to other private investors who are interested in investing.
      • Stock Dilution: Reduce the impact of their shares by increasing the total number of shares, which dilutes everyone's stake proportionally but may be necessary to rebalance the cap table.
      • Purpose: You might need to discuss and negotiate with early investors like universities, accelerators, or angel investors.
      • Goal: The aim is to adjust their holdings in a way that is more favorable to the executive team and appealing to future investors, ensuring that the cap table supports the company's strategic direction.
2. Recapitalization: In some cases, a complete recapitalisation may be required to fix a messy cap table. While this process can be complex, involving reissuing shares or creating a new class of stock, it can be the best way to reset the cap table in a manner that aligns with the future success of the company.
   1. When to Consider Recapitalization:Step by Step:
      • Necessity: If the cap table has become overly complex or misaligned with the company’s growth objectives, recapitalization can simplify and realign equity stakes.
      • Complexity: This process might seem intricate because it involves legal changes to share structure and ownership. However, it's a direct method to address fundamental issues with the cap table.
      1. Reissuing Shares: Adjust the number and type of outstanding shares. This could mean consolidating multiple small shares into fewer larger ones, or vice versa, to better distribute equity.
      2. Creating New Classes of Stock: Introduce different types of shares (such as preferred shares) to attract different kinds of investors or to prioritize certain rights (like voting power or dividends) over others.
3. Redemption of Shares Held by the Investors: This is commonly observed in a down-round scenario, where the company's subsequent valuation dips below its previous mark.
   1. Why It Happens in a Down-Round:Step by Step:
      • Down-Round: A down-round occurs when a company raises funds at a valuation lower than in previous funding rounds. This often indicates challenges or decreased market confidence in the company’s growth prospects.
      • Purpose of Redemption: In these situations, redeeming shares can be a way to consolidate ownership, reduce the number of external stakeholders, and stabilize the company's equity structure.
      1. Identifying Shares for Redemption: The company decides which shares to buy back, often focusing on those held by investors who may no longer align with the company’s long-term vision or who are looking to exit their positions.
      2. Financing the Redemption: The company must ensure it has the financial resources to buy back the shares, which could involve using cash reserves or securing new funding at the new valuation.
4. Purchase of Secondaries from Early Investors: This allows startups to buy back shares from their initial investors, offering more control to the founders or ushering in new investors who align with the company's vision
   1. Why Consider This Strategy?Steps Involved:
      • Control and Alignment: This approach allows startups to regain or increase control by the founders. It can also make room for new investors who share the company’s current vision and strategic direction.
      • Early Investor Exit: Provides an exit opportunity for early investors who may be looking to realize gains on their early support or who prefer to step back from the venture.
      1. Identify Shareholders Willing to Sell: Engage with early investors to gauge their interest in selling their stakes.
      2. Valuation and Negotiation: Determine the value of the shares based on current company valuation and negotiate the terms of the buyback.
      3. Secure Financing: Ensure adequate capital for purchasing these shares, whether through existing cash reserves or external financing.

Conclusion:

Cleaning up a cap table is essential but complex. It demands a proactive, detailed approach to ensure that all stakeholders, particularly the founders, remain dedicated to the company's goals. Successfully doing so not only prepares the startup for future investments but also solidifies the commitment of everyone involved towards achieving shared success.

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