By Andrew Chen, Venture Partner
As an investor in the science and deep tech space, I hear a lot of hand-wringing on cap(italisation) tables. The official record of who owns what portion of a company, these tables can make the difference between an investor genuinely engaging with a company and tossing it aside with an offhand comment of “the cap table is screwed”. Investors are often looking for reasons to quickly say no, and the cap table is a common place to find problems.
There are lots of reasons for why a cap table might be deemed “uninvestable” – here’s Wellington-based angel investor Dave Moskovitz on “messy” cap tables, with a really good framework for understanding the challenges: https://dave.moskovitz.co.nz/2022/02/10/fun-spun-under-the-gun-done-dealing-with-messy-cap-tables/. As Dave writes: “Most early stage investors prefer a “clean” cap table, where the founders haven’t given away too much too soon, have retained a lion’s share of control, have steadily built value over time, have attracted a small number of smart, respected, aligned deep-pocket investors all wrapped up in a tidy package.”
But the message to add here is that investors shouldn’t judge cap tables too quickly. There is often more story and narrative behind the scenes that can significantly change perceptions, especially in deep tech. As an example, here’s a hypothetical cap table after one round of investment, loosely based on some real scenarios we’ve seen over the years:
If an investor saw this on the Companies Office, they might conclude that the two founders only have 39.2% equity between them – way too low after the seed round for the founders to be considered “sufficiently incentivised” to turn the company into a billion dollar proposition. The investor might criticise the university for holding 45.1% post-money (by adding the University Nominee and University TTO holdings together), as it could be implied that they “took” 53.5% of the equity at company incorporation before investment. But that could be a very wrong conclusion – what are some of the things hidden behind this cap table?
- There is a Founder C, who wanted to avoid a perceived conflict of interest with a potential grant funder, so their 15% (pre-ESOP) stake is held on their behalf by the University Nominee. Everyone agreed it was a practical solution to manage a potentially perceived but immaterial conflict.
- The 5.9% held by the University TTO is for a financial capital contribution made from their investment fund, and therefore should be treated the same as any other financial investor, not as baggage from a spin-out.
- Accounting for the above two points, the pre-investment equity holding from the university is 30.9% (held in the University Nominee only). You can still argue whether this is too high or not, but don’t argue with me because this is a hypothetical scenario. In exchange for this, the TTO has covered the costs of protecting IP (which will be assigned to the company for free when it raises a couple million dollars) and the university is providing a lab lease for free for two years, in addition to grants and operational support pre-investment. All in all, this was a couple hundred thousand dollars worth of value, before any investor was willing to even hear about the project.
- There is a 15% ESOP pool, which appears in company spreadsheets to calculate fully diluted shareholding but doesn’t appear on the Companies Office. Some of that is allocated to the three founders but it is mostly allocated to other key staff. Staff in the company (including the founders) hold 61.1% of the company fully diluted. The investors are holding 18.3% fully diluted. I’m not saying that this is necessarily a good or bad split, just that it might not be what you expected from the table above.
- Founder B is close to retirement, and is planning to leave the company in three months. Half of their shares are unvested and will be bought back by the company for $1 in aggregate and then reallocated to the ESOP pool.
- At this stage, the company has received one tranche of funding out of two scheduled in the subscription documentation. In the next couple of months, if the company achieves its milestones, the current investors will pay a smaller second tranche into the company, bringing them up to 25.2% fully diluted.
- The passive investor is one that has historically had a poor reputation for being difficult to work with, but there has been a change in management in that fund recently and the new folks are much better to deal with and provide more support to the company – they just haven’t met with most of the ecosystem yet and are slowly rehabilitating their image.
- From the Companies Office, you can’t see that the investors all hold preference shares, while the founders and university nominee hold ordinary shares. This means that in the event that the shares are liquidated, the preference shareholders will be paid out first to recover their investment before the ordinary shareholders are paid.
Doesn’t this all seem like pretty material information to understanding how to interpret the cap table? The context paints a very different picture of how much equity the key people in the company hold, and how “active” the shareholding is. It seems unfair to me to dismiss an investment opportunity simply because a search on the Companies Office has returned an “uninvestable” cap table. A fully diluted cap table spreadsheet in the data room might reveal a bit more, and hopefully the founders have added some notes to explain things like Founder C’s nominee shareholding. Maybe it’s more fully explained in an Information Memorandum (IM), or we just need to talk to the founders to find out more. Communicating the nuances of a complicated cap table is challenging for founders, but as investors we need to ask the right questions too.
A more comprehensive cap table in the data room might look like this:
|Shareholder||Current||After Tranche 2|
|– Founder A||250,000||16.7%||250,000||15.3%|
|– Founder B||250,000||16.7%||125,000||7.6%|
|– Founder C
(held by nominee)
|– University TTO||75,000||5.0%||112,500||6.9%|
|– Lead Investor||150,000||10.0%||225,000||13.7%|
|– Passive Investor||50,000||3.3%||75,000||4.6%|
Some investors might be reading these hypothetical numbers and muttering “this is a dumb article, the cap table is still broken”. As Dave Moskovitz writes also: “There is no cap table problem so big that it can’t be solved.” Yes, recaps (recapitalisation) are painful for everyone involved, but sometimes they are necessary and investors should be prepared for them. If a company is otherwise successful – good tech, good commercials, good team, good almost everything – it seems regrettable that a company could fail to raise capital just because of a cap table, something that is constructed by the humans involved in and around the company and in their control. There is enough uncertainty and risk in all the other parts of the business to let internally negotiated finances be the pitfall.
All of this is to say – jumping to conclusions may mean an investor misses out on a good investment opportunity, and ultimately that would be their loss. Don’t be lazy – spend a bit more time to get the full picture so that you can make an informed decision about whether or not the cap table is actually problematic enough to be a showstopper. And for founders, if you know you have a complicated cap table, front foot it in your pitch or IM with potential investors.
Thank you to my colleague Kiri Lenagh-Glue for helping review this article.
Featured Image generated with DALL-E, “digital art of an analyst struggling to understand a spreadsheet.”