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Jul 23, 2019

Uninvestable Startup. How to fix a broken cap table?

“Mistakes were made”, and some of them are not that easy to fix. What to be aware of, when you are creating your first startup, and how to keep your business attractive for the investors?

More often than I would like to, I meet uninvestable startups. These companies, despite having a good technology and team, are unable to attract new investors due to their ownership structure.

The obstacle is that the founders hold a relatively small amount of shares in the company, which discourages potential investors who are afraid that the founders may be poorly motivated. While there are no rigid rules, ideally, after the round A, the founders would own at least 50% of shares in the company, and employees would have another 10% (e.g. in the form of ESOP).

In my experience, there are three main reasons for the over-dilution of the founders in the ownership structure of their company:

  1. the first investors received too many shares,
  2. the companies were created as part of the spin-off
  3. some or all of the founders left the company.

 

In each of these cases, I met companies in which the active founders had less than 30% of shares after the seed round (and in extreme cases even only a few percent). The first investors received too many shares

Not all founders have the chance to bootstrap their startup until an MVP and the first revenues. Thus, they often face the dilemma of obtaining the first, relatively low funding, several hundred thousand euros, in return for a relatively large amount of shares in the company. Of course, it is difficult to value a startup at such an early stage, as most of the valuation models are based on the measures of revenue and profit; and investments at such an early stage are made based on team and product potential.

For the above reason, safe notes is a good mechanism when founders cannot get into a compromise with a potential investor regarding the valuation.


Safe notes

Allow the investor to buy shares at a discount in the next/future funding round without having to specify the value of the company at the time of the initial investment. It was invented by founders friendly YCombinator and become the alternative to convertible bonds.


Vesting

An alternative to the safe notes may be vesting clauses, in which the investor receives a larger stake in the company (ie at a lower valuation), but at the same time commits to reduce their share after achieving the set KPIs. Vesting is usually triggered by delivering of expected KPI’s that could be sales revenues or next round investment.


Other opportunities… 

If you have no other choice than to give the first investor more shares in the company than it’s expected, you should at least agree in writing on the principles of reducing his stake in the future. If you do not do it right away, there is a big chance there will not be a possibility to resolve this issue later. Not all investors are willing to give away their shares without prior arrangements, even if it means no further financing round is possible.


Spined-off startups

In Poland, we have a relatively small number of spin-off projects created at universities / scientific institutions, but more and more of these types of projects come from software houses. Unfortunately, in many of these, the software house has more than 50% of shares in the company, and sometimes even close to 100%. This means that a relatively small amount of shares in the company are owned by the founder and a key team involved in the development of spin-offs. These types of projects rarely get financing, at least as long as the spin-off entity does not reduce their exposure to 10-15%.


Departure of founders

Even the best teams of founders may not stand the test of time and fall apart, either due to the differences in their vision, or personal, health or financial reasons. Regardless of the cause, the departure of one of the founders, who is also a significant shareholder in the company, has serious consequences and can make the startup uninvestable. Investors pay special attention to the number of shares held in the company by the founders who are active in the development of the startup and dedicate 100% of their working time to it.

The founder agreement, under which the reverse vesting mechanism is introduced, obliges the founder to resell part or all of his shares to the other founders if he decides to leave the company within a certain time (usually 4 years). Unfortunately, these types of agreements are rare, especially in Poland, which is why some venture capital funds (including bValue VC) include reverse vesting in their investment agreements. These clauses protect not only investors but particularly the operating founders.


Summary, or how to avoid mistakes in the ownership structure

Since the first day of building a startup, its founders should think about the ownership structure and subsequent financing rounds. Postponing it in time and acting without a previous plan may increase the risk of not being able to attract investors. First of all, the founders should sign a founder agreement and introduce reverse vesting clauses. Also, if it is not possible to bootstrap and you need to acquire the first investors at the pre-revenue stage, you should offer them a safe notes or set a vesting program, under which, after reaching certain KPIs, the founders will increase their share in the company (either in the form of buy-back of shares from the investor or by taking up new shares at a nominal price).

 

Paweł Maj

Investment Director at bValue VC

 

Paweł Maj has over 19 years of experience working on capital markets in the investments (including venture capital transactions, pre-IPOs as well as investing in distressed assets, he participated in dozens of transactions with combined valuation of €25m., several of which ended with successful exits – among them 5 through Warsaw Stock Exchange IPOs) and advisory capacity (including advising with IPOs, SPOs, M&As and debt financing; participated in dozens of projects, with overall transaction value exceeding €180m., the largest and most complex project that he worked on are Konsorcjum Stali S.A. and Gobarto S.A.).