Hey friend,

Of all the VCs, that I hosted on the podcast (more than 50) I asked them a few questions repeatedly. One of those questions was ‘What are the cap table red flags for you?’

I thought I should share all that I have learned from my guests and my personal learnings. Collectively, these VC partners have reviweved more than 100k cap tables in the last couple of years.

Without making this edition a painful read, I’d split this into two parts.

Part 1: Why you need a cap table, whats a messy cap table, what makes a cap table messy or uninvestable, and how to avoid it?

Part 2: 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.

Who needs a cap table?

So, lets start with whats a cap table and who needs a cap table? I never liked definitions, you can just go and google that. In plain english, its a simple spreadsheet that outlines who owns what percentage of the company. That includes, founding team, angel investors, future investors, universities (in case of a spinout) and/or venture studios and accelerators.

This excel sheet, or tools like carta, cake, etc. which are much more advanced exit to determine the growth and exit of the company.

If you are building a venture backed startup and planning on fundraising, you need need this document. If you are first time founder, you really need to keep it clean because this one document will impact the voting power, ownership rights, and decision making.

This is what a Cap table usually looks like.

I’ll write another one of these newsletter explaining each and every term you see here and how the math works. But, thats not the topic for today.

What is a messy cap table?

If you plan to raise external capital, a clean cap table gives investors confidence that founders have managed the ownership structure effectively without complications.

A clean cap table simplifies the due diligence process for future investors by allowing them to quickly evaluate the ownership and equity distribution and understand any restrictions.

All VCs more or less share the same reasons. So, I’m grouping them into a few categories.

Dead Equity:

When you are starting out, its important to build a founding team that buys into your vision and help/support you to achieve the vision. Most founders and startups dont have enough cash or revenue to attract great talent and offer a great renumeration package. So, equity becomes an integral part of the renum package.

This is very acceptable and encouraged by VCs. One VC also said this:

If the founders dont have an ESOP (Employee Stock Option Plans) that is yellow flag. We want to see a team that is invested in the idea but ofcourse with vesting schedule in place.

Its very common to see early employees and founders having a fall out and parting ways. There are tons of reasons (both good or bad) which will see a founder leaving the team early on. The equity given to that founder who is no longer a part of the team is considered as dead equity.

Suppose, that founder had 10% of the equity before dilution. After he left, the founder, angels, venture studios etc are left with 90%. The absence of 10% is a huge red flag to VCs. (We will go deeper into fixing this problem in the part 2 of this edition).

Investor with influence:

If you have an investor on the cap table who holds a significant equity, that’s a major red flag for VCs. Why? Such investors will control the direction and growth of the company. They might not be open to pivoting when its actually the right choice.

And in later stages, having a strong investor on the cap table that is misaligned can only be detrimental. We have seen a lot of lawsuits, founders getting fired, and all kinds of legal issues in this category.

Equity Imbalance:

Equity imbalance is by way the most common that I have seen. So, equity imbalance, simply put, means the investors own more than the founding team at the early stages. Take a look at the image below.

In this example, the investors own twice as much as founders. This is a huge red flag. (its fixable and we will talk about that later). Its a problem because, in the subsequent rounds after dilution, the founders will not have much left in terms of equity and their incentives will me misaligned.

That will leave investors in a bad spot when founders aren’t putting as much efforts as needed simply because they lost the motivation to do so.

Too many investors:

You might be thinking why is that a problem? Right. Lets take this hypothetical scenario to explain this.

A startup ABC has 10 angels on the cap table. They are not combined into a single entry. If, a couple of those angels have gone MIA or they are not responding or you dont have the updated contact details, this further complicates the process of due diligence for the VCs.

Usually, university programs and founders with too many angels on the cap table experience this problem. They are amazing to get the ball rolling but they will not very helpful in the later stages.

There are a lot of equity management tools out there that you can use for this purpose.

All these reasons contribute to creating a messy cap table. VCs treat them as major red flags and even though the team, company, idea, market, etc. all looks great but these could be a massive dealbreaker.

So, how to avoid these?

These are the few tips on avoiding these issues. If you already have a messed up cap table, wait for the next edition.

Tip 1: Limiting the #s of investors

The goal is not to have less investors on the cap table. The goal is to have less entries so its easy to understand. In order to do that, you can use Angel List’s RUV (Roll Up Vehicles) or angel syndicates to consolidate smaller checks into 1 bigger check.

Tip 2: Implement the vesting schedule from day 1

Have a vesting schedule. Period. Regardless of who you are hiring and giving away ESOP, make sure they are on a vesting schedule. Usually, that is 4 years with a yearly cliff.

Some VCs also recommended to have a reverse mechanism in place from the get-go.

Tip 3: Right valuation and right equity

Most founders (I can testify to this) optimize for a higher valuation. ​Negotiating for the higher valuation​ is a huge problem.

Value your company properly, avoid inflated valuations, avoid giving up too much equity early on.

Tip 4: Who to add and take help from?

Dont give away 5% to advisors, friends and family, etc. Talk to fellow founders ( we building a community of founders to help you navigate challenges like this).

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