A cap table, short for capitalization table, is a document that outlines the ownership structure of a startup. It shows who owns what percentage of the company and how that ownership is divided between different classes of shares. A cap table is a critical document for any startup, as it helps investors and founders understand the ownership structure of the company and can be used to value the business.
However, sometimes a cap table can become broken. This usually occurs when the founder team has been diluted too much too early, meaning that they have lost a significant amount of ownership in the company before it has had a chance to become profitable. In this article, we will explore different methods for fixing a broken cap table in a startup. You should also read the article
Why Startups Should Avoid Having a Broken Cap Table that will give you a bit more insights.
Understand the Problem
The first step in fixing a broken cap table is to understand the problem. This means taking a close look at the cap table and identifying where the dilution occurred. Often, dilution happens when a startup raises money from investors in exchange for equity. If the terms of these investments are not carefully negotiated, the founder team can end up losing a significant amount of ownership in the company.
Other common causes of dilution include issuing too many shares too early, granting too many options or warrants, and failing to properly account for convertible debt.
Solutions
Negotiate with Existing Investors
If the founder team has been diluted too much too early, one option is to negotiate with existing investors to try to regain some ownership in the company. This can be a difficult and delicate process, as investors will likely be reluctant to give up any of their equity.
However, it is possible to negotiate with investors in some cases. For example, if the startup has not yet achieved its goals or has encountered unexpected challenges, investors may be willing to renegotiate the terms of their investment. Alternatively, the startup could offer investors some form of incentive to give up some of their equity. For example, the company could offer to buy back some of the investor’s shares at a premium or offer the investor some other form of compensation.
Raise Additional Funding
Another option for fixing a broken cap table is to raise additional funding. This can be a challenging task, particularly if the founder team has already been heavily diluted. However, if the startup has a compelling business model and strong growth potential, it may be possible to attract new investors.
When raising additional funding, it is important to carefully consider the terms of the investment. Founders should aim to negotiate terms that are fair and reasonable, while still allowing them to maintain a significant ownership stake in the company.
Consider a Reverse Stock Split
A reverse stock split is a process in which a company reduces the number of outstanding shares by a certain ratio. This can be a useful tool for fixing a broken cap table, as it allows the founder team to regain some ownership in the company. For example, if a startup has 1,000,000 outstanding shares and the founder team owns only 10% of those shares, a 1-for-10 reverse stock split would reduce the number of outstanding shares to 100,000 and increase the founder team’s ownership to 100%.
However, it is important to note that a reverse stock split can have negative consequences as well. For example, it can signal to investors that the company is struggling or that management is unable to grow the business.
Use Equity Compensation
Equity compensation is a process in which a company grants stock options, restricted stock units (RSUs), or other equity-based incentives to employees, advisors, or other stakeholders. This can be a useful tool for fixing a broken cap table, as it allows the founder team to incentivize key stakeholders without diluting their ownership in the company. But we aware that that might also be taxation issues if too many options are given to the founder team at once.
Relaunch The Company
This should always be the last option but in some cases it might be the only one though it’s risky, time consuming and not very nice. If founders end up in a deadlock with investors that are not willing to solve this then founders could consider this. It will create a clean sheet with a new ownership structure and could potentially be done while raising new funds. But there are huge downsides with this approach. First of all the old investors will lose their investment. The company IP (brand, technology and more) will end up at the curator after the bankruptcy and will need to be bought by someone. Of course the founders would like to do this, but there is a risk that it will be sold to someone else. Also, all employees will be gone and would need to be rehired in the new company if they want to.
Conclusion
A Very Time Consuming Task
Fixing a broken cap table is a very time consuming task that will take away focus from growing the company and creating value. Avoid getting a broken cap table by all means. It will take up a lot of the founders time and can last for 3-24 months. Instead founders should keep an open conversation with their investors about why it’s important to keep a market conform cap table and solve the problems along the way. The investors have an interest in getting a return on their investment and so do the founders. Everybody are in the same boat and it’s better to make the company succeed than to hold on to something that investors and founders will lose anyway. Make the bright choices and explain why this is important to investors.
Always Forecast The Long Term Dilution
If you want a tool that can help you forecast the dilution of the founder team, investors and more then feel free to
download the free dilution calculator and fundraising forecast tool.
