Having a healthy cap table is important in order to ensure the investability of the company going forward. In this article we look into a healthy cap table and how to take the cap table into account in future funding rounds.
Why the Cap Table Management is Important?
As investors like to maximize the return on their investment, trying to minimize the valuation is quite common. However, the investors should not be too greedy: Getting greedy on acquiring a stake is not necessarily beneficial to the investor. By taking too much equity, the investor may mess up the cap table in a way that the founders and key employees are not compensated adequately and/or that further investments become challenging.
Founders should always have a sufficiently larger stake in the company. For one, they need to be motivated in pushing the company forward today. Two, they need to have enough stake in the game after the future funding rounds. And three, there needs to be a problem owner when things become challenging.
For example, if the stake of the founders in a company is 20% and the valuation of the company is 1 meur, there is very little incentive for the founder to push for doubling the valuation in the next two years. This would make him only 100 keur per year, with huge risk; probably something that a talented person could get as an employee for some corporation on a lot lesser risk. And this will keep the prospective future investors out. Also, if the founder's stake is only 20%, why would the founder spend sleepless nights and pushing 80 hour weeks to save the company, while the holders of the remaining owners do nothing (but would still get 80% of any value created).
Magic of the A-round
So how to keep the cap table investable? My starting point is typically the A-round: After the A-round the founders need to have still over 50% of the company.
What makes A-round so special? Startups that pass the A-round usually also survive the valley of death; any potential future funding rounds are more about growing the company. Thus, the risks are higher until this round: Until A-round failure equals liquidation, but from B-round onwards failure still lets the company survive.
Rounds before A-round
As we lock the post-A-round stake down, we can start building an outline for the funding rounds that keeps the cap table intact. In A-round we can expect to give out 20% of the company. Thus, in order to keep the founders' stakes intact, we can dilute a total of 25%-35% in the previous rounds.
If we expect to run a preseed and seed round before the A-round (and leave room for a bridge round, just in case), we need to ensure that the dilution stays within the limits. 10% in preseed and 20% in seed equals 28% dilution, leaving room for one smallish bridge round (below 15%). Preseed dilution of 10% with seed round dilution of 10% would leave more room to maneuver.
Some rules of thumb that can be used when determining how much equity you can give out (out of 100%) in each funding round before the A-round can be found below. All these leave also room for one bridge round if needed.
Rules of thumb - Round before A-round
One round 25%
Two rounds 10% + 20%
Three rounds 5% + 10% + 15%
What If the Founders Become Over-Diluted?
Every now and then you see I situation when the founders have become over-diluted. This can be e.g. due to taking in too much funding with too low valuations or need for several bridge rounds.
If the company is otherwise investable, the cap table should not be an unsolvable issue. I deal with tools on solving a complicated cap table in a separate article here.
Point of View
The size of the funding round should be determined by three elements: Reasonable runway for future plans, current status and opportunity of the company and cap table management. While it would be tempting to secure a long runway by taking down more financing, may this cause over-dilution and cap table issues. Thus, you should always consider how to keep your company investable when giving out equity.