Discover the most frequent cap table mistakes founders make and which investors find problematic in startup funding from Pawel Maj at Warsaw Equity Group.

Today, we want to introduce you to a series of articles developed together with a seasoned investor and expert in venture capital from our region.

So, without further ado, let us welcome Pawel Maj, an investor that we’ve been following in the past years, especially on Linkedin, where he is educating his audience with educational content and useful data for founders about different things on venture capital.

In the first part of this series, we discuss cap tables and their role in a startup’s life. From what a cap table is, why this is an important asset for a founder looking for fundraising, and the best practices to avoid ending up with an uninvestable one.

Who is Pawel Maj & Warsaw Equity Group

Pawel is a Partner at Warsaw Equity Group, a late-seed & Series A venture capital and private equity investor. He previously co-managed three funds and, until now, completed +60 investments and 20 exits in his portfolio.

“I am active in the world of venture capital funds and private equity and co-managing them since 2010. It’s been 14 years, and now I am leading my fourth fund.

I previously worked as a financial advisor for an advisory boutique focused on mergers, acquisitions, IPOs, and subsidies. So, I’ve been closely working with founders in one way or another on equity management problems since the early 2000s.”

Pawel loves to work closely with founders, and between 2021 and 2022, he also supported startups in their fundraising process, mostly focused on pre-seed and seed rounds, closing on average one round per month.

“So, I have experience not only as an investor but also as a mentor and advisor.

I was one of the most active people in the industry in Poland, probably at a given moment, even in Central Eastern Europe, since I’ve been closing on average one round per month.

I’ve worked closely with founders on structuring their equity, organizing their cap tables, finalizing transactions, and acquiring money from investors, typically venture capital funds.”

What is a broken cap table, and when does it happen?

Problems with your ownership structure can be a deal breaker in the eyes of your potential investors and negatively affect your transaction.

“A broken cap table, from my perspective, means the ownership structure of previous investors is problematic for future investors.”

We wanted to look at a cap table from all sides, so we asked Pawel to share his view from the start and pinpoint what this is and how often he encounters it in his daily activities as an investor.

Here’s what he said:

“A broken cap table happens at all stages of a company, but the later stage of the company is, the less important the structure of the cap table.

If you are on the path of fundraising from a VC, then the structure of the cap table is very important. However, the cap table structure is not that important if you are bootstrapping or are more likely to aim for exit towards strategic investors and public markets.

For a strategic investor, for example, if they want to acquire 100% of your business, it doesn’t matter for them from whom they are buying from.”

6 common cap table problems in VC fundraising

Each difficult situation in your cap table can come from a different root cause, and there are many particularities for each fundraising round.

However, there are various common causes of problems in the cap table, and we asked Pawel to guide us through some of the most commonly encountered ones.

1. Give too much equity to existing investors.

The first case that’s most likely to happen is when the company valuation is too low, and founders decide or have no other option to give away more equity than they should.

Here, there are two cases Pawel wanted us to look over. One is focused on companies fundraising their first round and how giving too much equity affects their cap table.

“When founders give a larger percentage from their company, it comes from different reasons. A frequent one is because they are unaware of market standards and don’t know how they should work with their ownership structure.

In other cases, founders are aware of market standards but don’t have other alternatives because they only received one term sheet. Especially if your company is not the ideal case for venture capital funds because you are not growing as fast as they would like you to, you operate on a very small niche, or your solution is still very local with low traction on international markets.

In this case, you have two options:

1. You accept an investment proposal that’s not ideal and takes too much from your equity.
2. Leave the offer on the table and accept that you must reduce costs to reach a break-even point or close your business.

However, you have more options and negotiating power if you have multiple investment offers.”

2. Give too much equity in follow-on rounds.

The second case is more focused on the impact of giving too much equity over your next follow-on rounds, and here is what Pawel shared with us.

“I recently discussed with a company that raised a round from both VCs and angel investors and now has 100 investors in their cap table. So, if you look at it from a visual perspective, you need three buses to gather all your investors.

This might not look like a problem for your existing investors, but it is definitely one for future ones. When you try to negotiate a deal and have everyone agree, it will be very difficult to find a solution that will meet all their various expectations, such as time to exit, valuation, liquidity, and terms in the investment agreement.”

But are there any available solutions to avoid cap table problems? Pawel advises us on how to treat the situation where many investors are joining.

Create an SPV.

“You can have more investors in your cap table. This is not the core problem if you anticipate and plan for the future.

If you create a separate investment vehicle (SPV) through which they represent one legal entity in your company, then you’ll only have one shareholder joining your cap table. This is a solution often used in equity crowdfunding.

However, if you have 100 investors, it will be very hard to bring everyone to the same table and have them sign an investment agreement."

Give power of attorney to one individual.

“The second solution, which is less ideal for managing the ownership structure when too many investors are joining, is to give power of attorney to one of the investors to represent the other 99."

Having these in mind, we asked Pawel to share how these situations look from an investor's point of view and how they affect his investment decisions.

“As a pre-seed and seed investor, I never invested in a company with over 20 investors in the cap table, including the founders, angels, and venture capital funds.”

When does a cap table exactly get broken?

“When looking for your first investors, you will most likely raise your pre-seed or seed round from angels.

This is often when you make the first mistakes that can affect your cap table.”

3. Dealing with dead equity in your startup.

In startups, dead equity refers to company shares owned by individuals who no longer contribute but still hold a significant amount of stock. This can happen for several reasons.

“Let’s say one of the founders decided to leave the company, either due to a conflict or to a lack of common vision among the founders.

As investors, especially venture capital funds, we look at how much equity is in the hands of active employees, including founders and those who are part of an employee stock option plan. We want them to be fully involved in the company.

For example, if two founders have 50/50 ownership, and one decides to leave due to a conflict between them since the business is not doing as it was supposed to, but still keeps his equity.

In this case, there is a motivation problem for the remaining founder. Why would he build the company's value for two people instead of doing it exclusively for himself? The departing founder is a free rider who will have benefits without putting in the effort.

You have to sort out these situations and clean them up because it’s just a matter of time until they become problems. In the above example, active founders (engaged full-time) have only 50% of the business even before the first round/dilution - fundraising with such an ownership structure would be very difficult, if not impossible.

However, here is the part where things get complicated. It’s hard to anticipate no conflicts between two or more co-founders in the 10-20 years to come."

The importance of the founders' agreement.

A founders agreement is a contract that a company's founders enter into that governs their business relationships, clearly defining how much ownership each founder holds and what happens when any of them leave the company, avoiding future disputes and ensuring fair equity distribution. It’s a key component that you treat it right from the start; it doesn’t create problems for later, but if managed poorly, it only leads to conflicts and misunderstandings between founders.

But do founders use a founders agreement in our region, and what impact can it have in fundraising? Let’s find out from Pawel.

“If you don’t have reverse vesting, vesting rules among founders, or if you have not signed a founders agreement that regulates what happens with ownership when one founder leaves the company, it’s very difficult to sort it out.

Without instruments in place, you can try to negotiate, but it’s all based on human decency, and sometimes that’s failing us. It’s a lottery ticket. So, this is why I truly encourage everyone to sign a founder agreement as early as possible. You can start even before you actually build the company or soon after that.

Sit down with your partners and discuss what the role of each founder is, how time management will look like for everyone, what happens when one leaves the company, what happens to ownership for the remaining founders, do they have the option to buy it or not, when it will happen and how much will cost?

Founders agreements are still unknown, especially in Central and Eastern Europe. It’s better than it used to be 5-10 years ago, but is still insufficient. We need more awareness and education around it.

In all the transactions I’ve done in the past five years, I have not met a startup with multiple founders that came to me already with a document in place. As an investor, I had to introduce it to the company and make it a requirement for the investment round.”

4. You have a lot of convertible debt.

Safe notes and convertible notes are instruments used in startup fundraising that eventually convert into equity in the company. Choosing between safe notes and convertible notes depends on your specific situation.

“Convertible note agreement is a debt that can be converted into equity or is repaid with interest. On the other hand, a safe note is not a debt and is repayable only by converting it into equity.

When fundraising through safe and convertible notes, you must plan for it in your equity ownership plans. You must include it in your calculations, assuming they’ll convert into equity sooner or later.

You should not think convertible note agreements are debt financing because they can be converted into equity. So, if your company is doing well, you should expect your investors to exercise the right to convert the debt into equity, and your cap table has to include this.”

To better understand their role, Pawel guides us through an actual example.

“Today, we discussed a climate-tech project, a seed stage company with very small revenue but already with over 50M EUR in debt.

For us, this is a difficult case. We must understand it deeply and identify if founders should convert into equity before our investment, but that would dilute too many current shareholders (including founders), or if founders and investors should consider restructuring part of that debt. It’s a difficult decision to make.

If you have too much debt, you should anticipate this will be a problem for future investors. They’ll allow you to restructure or convert it into equity before investing. Otherwise, we’ll be hesitant to do the deal because part of the money will go into paying the historical debt instead of growing the business, which makes no sense, especially when a company needs capital for further growth .”

5. Previous rounds done at too high valuations.

Having previous funding rounds completed at inflated valuations can present several challenges for a startup, both internally and externally. Here's what Pawel advises us:

“Maybe during the tech bubble, you could fundraise with an unreasonably high valuation, taking advantage of the macro-economic situation. But right now, you have a new round, and you’ll have to do it at a much lower valuation than before. We call these down-rounds.

Down-rounds are a problem, not only from a PR perspective but also impacting employees and investors. If you implement an ESOP, the shares will be worth less than they were two years ago, and the program, instead of motivating your employees, is affecting their morale. Similar to investors, they might have a psychological problem accepting that the company is worth 20%/ or even 50% less than it was during the previous round.

This might roll down even more because if you need investors' approval to do the transaction, it might be difficult to get it. Giving a green light for a transaction is difficult because you must admit you have overvalued the previous round and made mistakes.

If we’re talking about a 5%-10% down-round, things might get sorted out after a few discussions, but when you look at a more drastic valuation decrease, such as it was the case of Klarna, which dropped 86% between 2021 and 2022, it’s much more difficult to find to find ways to keep the company afloat.

Low valuations are problematic because you dilute yourself too much. But so are very high ones because they are unreasonable. It’s all about managing the expectations right.

If the stakes are too high, if the valuations are too high, it might be a problem for you, your current investors, and future ones to see how you’ll be able to finalize the next round in two-three years from now on.”

6. Startups created by venture studios don’t have adequate capital structure.

“Here, I would also include spinoffs from universities, corporations, software houses, and other similar formats. Usually, they take too much equity from the founders, and managers have little or no equity.

I have seen cases where they even owned 100% of the equity and hired managers to run the startup. In these cases, the company struggles, and from a VC perspective, they become uninvestable.

I previously worked with a seed-stage company where a software house owned 60% and only 40% founder. For a VC to invest in such a structure, there is a real problem. So, we had to fix the ownership problem and its cap table before presenting the company to investors for the next round.”

Connect with Pawel:

• Linkedin
• Medium
• Warsaw Equity Group

Want to learn more?

If you want to follow Pawel’s advice and learn more about cap tables, fundraising best practices, industry trends, and a snapshot of the venture capital market right now, prepare for your fundraising round, we’ve got you covered. Read more on SeedBlink blog.

However, if you’ve got everything in place with your funding and you’re now looking at how to implement an employee stock option plan and all things equity ownership, Nimity is here to help.

Our dedicated solution has prepared an easy-to-use platform to help you have everything in place and educational guides to understand the whole world of ownership.