Will Your Cap Table Hold You Hostage?
Of the many uncontrollable risks that early-stage startups face – product, market fit, or execution – what pains me the most is when I see a perfectly great company hampered, or worse, by an easily avoidable situation—Deadwood on the Cap Table. This situation occurs when cofounders, key hires or consultants leave the company early with a large percentage of stock. Losing a cofounder or key hire is challenging enough, yet if things aren’t set up correctly, the impact to your company could extend far beyond the loss of a cofounder.
The fundamental issue of deadwood is to demotivate those who are still operating the company. “I’m working 80 hour weeks to make this successful, but my former cofounder has a high-paying job and still owns as much of the company as me.” Investors are very sensitive to unfairly rewarding those who are no longer adding value to the success of a company. Eventually, they’ll want to see your cap table and if there’s too much deadwood, they may pass. The easiest way to avoid a future issue is at the beginning. While it’s possible to fix things later, it’s much harder, more costly, and might not work at all.
Often, start-up founders incorrectly assume that you simply decide on a fair split of stock and execute stock purchase agreements and off you go. This is a major mistake. It’s impossible to predict the future, especially in the dynamic world of a startup. Even when you get along well and trust each other, things can go awry. There are a multitude of reasons cofounders leave having nothing to do with ability or commitment, such as finances, divorce, illness, family moves, etcetera.
Clearly, anyone who contributes materially at any stage should have stock, even if they leave, but investors need to be sure that ongoing contributors are motivated and that non-contributors aren’t getting an unfair windfall. The best way to protect from cap table problems is to ensure that all participants, including the cofounders themselves, are subject to a vesting schedule of sufficient duration to see the company through to sustainability. How long will it take to prove your product and business model in the market? How long will it take for your company to build enough value to be self-sustainable or to achieve liquidity?
I generally recommend a four-year, monthly vesting schedule for all founders stock. In a stock corporation, this is implemented through a Restricted Stock Purchase Agreement. The company holds unvested shares in escrow and may repurchase them at the original purchase price in the event someone leaves prematurely. 3 years is not as good as four, and two years is just too short. The founders should also all sign Confidential Information and Intellectual Property Assignment agreements (CIIA) to insure that leavers don’t walk away with more than just stock.
To illustrate, let’s compare the cap table impact of one of three cofounders leaving after a year in three scenarios:
With a two-year vesting schedule, the person leaving ends up with ~18% of the company, pre-investment. In the case of a four-year vesting schedule, it drops to <10%. It’s unfortunate when someone doesn’t work out, but much better if it is not 18% to 30% of your company!
If you already have a problem, it’s best to take action quickly to avoid demotivating contributors or repelling/delaying investment. These situations can be delicate, but depending on your relationship with the exiting cofounder you can often simply negotiate a buy-back of some or all the shares. In a recent example, a founding CEO had a cofounder exit after just one year. After being alerted to the problem, the CEO successfully negotiated a buy-back, at par value, which reduce the cofounder’s interest from 36% to about 10%. Fortunately, the CEO/founder had good relationships with his ex-cofounder, but things were uncertain for a time. After the fix, the company was able to move forward with a clean cap table and much better shot at success. All parties benefit. In another similar scenario, a funding round was stalled for 3 months because the negotiations were protracted by an uncooperative ex-founder. Delays like that impact progress and create serious existential risks.
Even if relationships are strained, it may still be possible to successfully negotiate a buy-back of shares. The reality is, no-one wins if contributors are demotivated or the company can’t raise money or hire key people. Sometimes all it takes is to instill a dose of reality in the departing cofounder that an adjustment now will improve the possibility of a successful outcome. If the situation is truly dire, a restructure or restart may be required, but such things can be legally complex and very distracting. Perhaps the most powerful tool you have in such negotiations is your willingness to continue under the circumstances. If pressed, there is always the “nuclear” option that can be offered for consideration.
Solving cap table deadwood is a necessity to ensure motivated founders and investors, so if you can’t avoid it to begin with, you should do whatever you can to handle it early while the stakes are lower and before it causes other problems.
Sage Partner David Currie contributed this Sage Advice