My previous article was about the importance of an investable cap table. However, every now and then I see companies that would otherwise be fundable but are struggling to get funding due to the cap table, i.e. founders not having enough stake in the company.
While the best way to avoid this situation is to not give out too much equity in the first place, there are also other tools that can be used in order to solve the situation. In this article we take a look at some of these tools.
Tools to Avoid Overdiluted Cap Table
The best solution to keep the cap table investable is to avoid overdiluting it. While the dilution is inevitable in equity investments, there are some ways that can be used to reduce the dilution.
Taking in Smaller Rounds
The most common reason for over dilution is taking in too much cash when the valuation is low. Thus, if the valuation of the company is low and therefore the dilution would be significant, it might make sense to divide the funding into two rounds: A smaller one first and a larger one once the company has made progress and the valuation is thus increased.
Taking in smaller rounds makes the most sense in the early stages of the company when achieving certain steps can increase the valuation significantly.
For loans, you do not need to give out equity, so using loans as a part of financing can reduce the dilution. Once the valuation is higher, you can take in additional equity with lesser dilution and use the equity to pay out the loan.
Loans are useful especially during bridge rounds. When using loans it should be noted, though, that having too much debt in the company can make it non-investable as well: The investors want to see their investment going mainly for creating new growth for the company; if significant part of the funding would go to pay out existing debt, some investors may back off.
If the company is in a stage where the valuation can be expected to increase significantly shortly, convertible notes can be used to postpone the valuation event on a later stage and, thus, reduce the dilution.
Like taking in smaller rounds, convertibles are most useful in the early stages of the company.
Tools to Fix the Cap Table
Despite all the tools listed above, every now and then a cap table gets messed up. In order to make the company investable again, there are some tools that can be used to fix the cap table.
The investors should note that all these tools require some kind of cut to the equity held by the investor. But keeping the company investable can increase the value of the investment, even if the equity gets cut down.
Transferring Shares to the Founders
Transferring shares from the investors to the founders is probably the most common way to fix an overdiluted cap table. The transfer can happen for free or for a price. Alternatively, the company can also issue new shares to the founders, increasing their stake in the company.
Usually, the transfers happen for free or against a nominal compensation. Transfer at the fair value would require that the founder could finance the transaction which is usually challenging.
Redemption of Shares Held by the Investors
Redeeming shares from the investors reduce the investors' stake in the company increasing the founders' stake.
As with the transfer of shares, also the redemption usually is conducted below the fair value of the company. Redemption of shares is treated as a profit distribution; thus, the company should have sufficient equity in order to carry out the redemption.
Founder options give the founders the right to subscribe shares in the company on a predetermined price.
The main benefit from the founder options is that the so-called strike price, i.e. the price that the shares are subscribed for in the future, can be set at any level. This enables setting the price on a level that gives the founders sufficient incentive going forward while leaving the investors non-diluted up to that price. For example, if the investors have made their investment at €100/share and the company is now raising funding at €500/share, giving the founders options to subscribe the shares at €500/share would give them stake in any increase in value (and thus an incentive to push the value higher) while leaving the investors with full right to the €400/share of value created so far. In other words, the investors would only be diluted in the future increase in value, but they would not be diluted in the value already created.
Founder options may seem somewhat complicated, but in practice, those are quite straightforward. While they are not that commonly used, I see them as a valuable tool when trying to solve cap table issues.
Point of View
An overdiluted cap table makes the company non-investable. While fixing the cap table usually requires the investor to make some kind of concessions in benefit of the founders, but doing so will increase the instability - and thus the value - of the company. Knowing the tools for fixing the cap table can be helpful in assessing different options.