Your cap table holds the key to a big payoff for all your hard work, but there’s a few mistakes that can really cost you. Avoid these pitfalls to help maximize your equity value.
We help manage thousands of cap tables at Capshare, so we’ve seen plenty of mistakes that have cost equity holders. Our mission is to help everyone make smart equity decisions. That’s why we have compiled these common cap table pitfalls for founders to avoid.
1. Handshake agreements
Some founders make the mistake of simply agreeing to equity terms on a handshake without recording what was agreed upon. Most people are good for their word, but memories fade and misunderstandings occur. You want to get things down in writing as soon as possible so that nothing is left to chance.
At the very least, write it down on a napkin, then follow it up with an email so you have an immutable electronic record. You might also include a neutral third party to keep a record as well. Bottom line: don’t rely on verbal agreements.
Once you’ve agreed on the initial split, your best bet is to build your cap table on a platform like Capshare where you can record shares, issue paperwork and make it legal all at once. Talk with an attorney to make sure you issue the right paperwork, and you will minimize your risk of disputes.
2. Fully vested founder shares
When you first sit down with your co-founders, everyone has grand visions of the future. But in many cases at least one of the founders will go a different direction for one reason or another.
Hopefully they will part on good terms, but that’s not always the case. Regardless, you do not want a situation where a large equity holder is no longer contributing to the company. So most (if not all) of the founders’ shares should vest over several years.
Vesting simply means that the shares are earned over time. If a founder leaves the company early, he or she must forgo any unvested shares. It’s the same as getting paid every two weeks for a yearly salary. The salary is agreed to upfront, but it is only paid as long as the person continues to work for the company.
3. Failing to correctly analyze the impact of a financing round
Many founders don’t take the time or simply don’t know how to correctly model the impact of a new round of preferred stock.
You’ve probably encountered terms like liquidation preference, participation rights and participation caps. If you don’t know what these terms mean, you should take the time to learn how preferred stock affects the value of your equity. Many entrepreneurs have unknowingly given up too much value (through ignorance or by mistake) when negotiating terms.
You can know exactly how a potential financing round will affect the cap table if you have the right tools. There are plenty of spreadsheets out there to help you model things out, like this one by CB Insights. You can also create a free Capshare account to easily analyze different scenarios and combinations of terms to see how the cap table is affected.
4. Exercising your options too late
Incentive stock options (ISO’s) can provide option holders with favorable tax treatment. When the options are exercised, an employee pays no taxes. Instead the tax is paid upon sale of the stock.
This means that if the stock is held for over a year, the holder will pay long-term capital gains taxes. Long-term capital gains are taxed at a lower rate.
However, taxes will be higher if vested options are exercised when the company is sold. Since the holder will receive immediate income upon exercising, they will pay ordinary income taxes. Ordinary income tax rates vary based upon the holder’s tax bracket, but it’s usually at least 35%.
One additional note: In order to qualify for long-term capital gains – the sale of stock must also be at least two years from the grant date of the original option.
5. Failure to negotiate for early exercisable options
As mentioned above, if you exercise your options too late, you miss out on favorable tax treatment. And if your options are not early exercisable (early exercisable means you can exercise unvested options into restricted common stock), you might not even have a choice.
For example, suppose 25% of your 100,000 options are vested as of today, and your company has a good chance of exiting in the next year or two. If you decide you want to exercise now in order to get favorable tax treatment, you’ll only have 25,000 shares that qualify. You can continue to exercise shares as they vest, but at some point, you’ll start exercising within the one year window, and those shares will be taxed at a higher rate.
Conversely, if your options are early exercisable, you can exercise all your options (vested and unvested) at any time. The unvested shares will exercise into restricted stock, meaning you still have to stay with the company to earn those shares. But your shares now qualify for taxation at the long-term capital gains rate if exercised a year or more before exit.
6. Mispriced option grants
IRC 409a regulations require options to be granted with a strike price equal to or greater than the fair market value of common stock. Granting options too low could result in harsh tax penalties for employees, excess costs incurred by the company and hold ups during an acquisition or IPO. Conversely, if you grant options too high, employees will miss out on value they could have received otherwise.
This exercise can seem somewhat subjective, as the valuation of shares in a startup often feels like conjecture. However, the methodology for accomplishing this has more or less solidified over the years. To make sure you do it right, you simply need to obtain a 409a valuation (at least annually) with a reputable valuation provider.
A good valuation firm will be able to provide a valuation that sets the strike price low enough to provide reasonable incentive, yet defensible to audit firms, the IRS and the SEC. If you need a 409a valuation, Capshare is the best place to get started.
If you are looking for a guide on the process, 409A Valuations: The Data-Driven Guide is the best place to learn.
7. Poor record keeping
When it comes time for equity holders to cash out, the cap table determines who gets what. But the cap table is not simply an excel spreadsheet. It’s a collection of legal documents, agreements and records that tell the story of how ownership in the company has evolved.
So when a team of lawyers starts pouring over your records to determine how proceeds should be distributed, they’re not going to rely on some spreadsheet that’s been passed around over the years. They’re going to dig into all the legal documents to try and rebuild the cap table from the ground up.
For companies with disorganized cap tables, the lawyers often discover errors and missing information. They sometimes find significant differences between the legal documents of record and the spreadsheets that management and investors have been relying on as a representation of their equity.
Hence, you need to keep accurate records and make sure they agree with all the calculations used to model the cap table. Failure to do so can result in equity decisions using inaccurate information and can lead to surprises and holdups when the company exits.
8. Taking on too much money too early
The prospect of large rounds and lofty valuations can be enticing, but resist the urge to take on more money than you really need. You can end up losing control of your company to outside investors and risk your entire stake in the company.
This is exactly what happened with GetSatisfaction. The original founder and CEO, who walked away with nothing when the company sold, laments taking a big bet on a large round of financing when his company was still young. He eventually lost control of the company, got pushed out, then wound up empty-handed when the company sold in a firesale.
A large sum of money won’t suddenly make your business viable and worth the valuation implied by the investment. Only positive cash flow will make your business worth anything in the long run.
You basically have two options: 1) swing for the fences with a big round; or 2) raise as you go in smaller increments. There’s no right answer for all situations, but be mindful that a huge raise at a high valuation is not always the best alternative.
9. Negotiating the option pool pre-money instead of post-money
When you negotiate a term sheet, it will often have a provision for an option pool allotment. This is generally expressed as a percentage of the cap table. However, whether that percentage is calculated before the investment (pre-money) or after the investment (post-money) makes a difference.
If you carve out 10% of the cap table for options pre-money, that means only the existing shareholders get diluted by the option pool. In other words, if you want to incentivize people to help you build an awesome company, the existing shareholders have to cough up the equity, but the new shareholders get some of the benefit.
Additionally, if you don’t end up issuing all the options in the pool, you’ve essentially given the new investors more shares than they paid for. So if you have to carve out the option pool pre-money, at least make sure to issue all the options to get the full value of the pool.
Cap Table After Pre-Money Option Pool Carveout
Cap Table After Post-Money Option Pool Carveout
10. Failing to seek professional advice
The internet is full of blog posts, open source legal documents and pre-built spreadsheets to help you make sense of your cap table. However, none of these things can take the place of a qualified professional.
You will inevitably encounter nuances and legal complexities as your company progresses. In many cases, you don’t know what you don’t know. Only after the fact do you realize that you could have gotten a better deal or that you violated some regulation.
Never underestimate the value of advice from lawyers, investors, mentors, etc. Don’t be afraid to spend a few hundred or even a few thousand dollars to make sure you get the cap table right. You can put yourself in a much better position by seeking counsel from professionals who know what to watch out for and how to negotiate.
This is by no means a comprehensive list of all the mistakes you can make with your cap table. There are so many edge cases and nuances to cap table management, we couldn’t possibly give you all the advice you need in one article.
Cap tables might seem a little overwhelming, but don’t worry. Nobody gets everything perfect. If you can can at least avoid most of these mistakes, then you’ll be headed in the right direction.
If you ever need advice, hit us up on Twitter: @capshare. We’re happy to answer questions, and we’d love to get your insights as well.