Startup Pie🥧

13%

We recently looked at a crazy pre-seed deal.

Why was it crazy?

Because the founders owned just 13% of the company.

A pre-seed deal.

Oh, and they both had day jobs.

Red flag.

Cap tables matter.

The Observer Express

Don’t have time to read the entire post right now? No worries, here are the main points:

1. What’s a cap table?

2. What do early-stage investors look for when reviewing a startup’s cap table? We take a look at 6 questions they help answer.

What’s a Cap Table?

A cap table (short for capitalization table) is a ledger detailing ownership in a business.

Every company has one, and it serves as a key piece of documentation for investors to consider during diligence. It also serves as an important reference point for founders, employees, accountants, legal teams, and more.

The cap table breaks down how the ownership “pie” gets sliced, and is an ever-evolving document for startups who raise multiple funding rounds.

We request a cap table from every startup we analyze.

Here’s why.

6 Reasons Early-Stage Investors Care

Cap tables are important to investors for a few reasons. Here are some of the questions a cap table can help an investor answer:

1. Do you have one? I’ve been shocked by the amount of times I’ve opened up a startup’s submission to “upload your cap table here” only to find a garbled mess that wasn’t even remotely reflective of a proper cap table. No cap table, no understanding of what a cap table is, or have an unorganized/unreadable cap table? Red flag.

2. Who else is invested? Investors want to know who else they’re getting in bed with. If someone writes a $25,000 check for a piece of your pie, they know they’re only getting a small piece. They’ll be along for the ride, and knowing who else is on the journey with them is important. Someone I dislike? Someone I’ve been burned by before? Someone I frequently disagree with? Red flag.

3. Is there anything weird?Startup investors tolerate a lot of uncertainty. But something I’ve noticed, especially at the early stages, is that whenever something is “weird” it tends to quickly become a sticking point that they won’t tolerate. They’ll just pass and find the next one that’s not weird. If a cap table has some strange instrument listed (say, for example, a pre-seed deal has accepted a $100K investment from someone in exchange for complicated-looking warrants), it will show up on the cap table. That’s likely going to cause problems later. Red flag.

4. Are there too many names / Is it appropriately complex for the stage? I sometimes hear investors cringe because there are “too many” names on a cap table. What they’re really saying is that the cap table needs to be appropriately complex relative to its stage. A pre-seed deal should probably not have more than a dozen names on the list. A Series B financing is going to be very different. Obviously, there are exceptions here, but this can often be a very real yellow or red flag.

5. Do founders have a meaningful stake? Dilution is natural. It’s generally understood that as a company grows, the founding team is going to be diluted down, often exiting with less than 30% ownership in the firm. But when an exit is for $500M, a 30% take isn’t so bad. That continual dilution is fine since the overall value of the company and of the owner’s shares is increasing. But when that kind of dilution is present early on (such as in my opening example), it raises the question: how motivated is this team going to be? Red flag.

6. What does it take to get to 10x? Every investor has a different target outcome, but we typically benchmark what it would take to hit a 10x by developing what’s called a “pro-forma cap table.” Answering this question takes some work, so many investors tend to skip it, but we’ve found it’s very helpful for thinking through “what it would take” to achieve the type of outcome necessary to drive real return. For example, let’s say an entrepreneur is raising a $500K pre-seed on a 5m post-money SAFE. We could then model the next round based on industry average raise amounts and valuations, project resultant ownership levels, and estimate what kind of exit would be necessary to earn 10x. “Do you believe someone would pay $137M for this company within 5-7 years?” is a very different question from “Do you think they can successfully grow fast and exit?” If an investor doesn’t see a viable path to that kind of valuation, this could be a yellow or red flag.

Final Thoughts

Cap tables are an important component of diligence, and I think they’re often underappreciated at the early stages. Investors sometimes mistakenly assume that a cap table is clean and simple because an entrepreneur is raising a pre-seed round, but I’ve seen plenty that would suggest otherwise.

Takeaway from today’s note?

Look at the cap table before investing.

What do you think?

Do you typically include cap table analysis in your diligence? What about scenario modeling/forecasting?

Weekly Observations: 3 Lessons Learned

1. Defining clear “axes of better” is the starting point for strong positioning.📈In a very helpful conversation this week focused on improving PitchFact’s positioning, I was encouraged to consider the 2 “axes of better” that make PitchFact stand out from the primary alternatives. This would form the foundation for our simple positioning statement, and also allow us to build a pretty graph where our logo shines in the top right corner. Fun project.

2. Investors dislike feeling rushed.💨I’ve noticed founders often play the scarcity card (whether intentionally or not) by mentioning their round is almost closed or by proposing a firm close date. More often than not, the angels we work with tend to be off put by this, and will instead opt to pass on the opportunity since there’s “no time” to run through their normal process.

3. Complementary partnerships alleviate the pain of saying “no”.🤝We can’t do everything. At first, it was easy to say “yes” to anything that was interesting while we got the company off the ground; now we’re learning to say “no” to things outside our core competency and (try) to stay focused on what we do best. That’s where I’m finding partnerships with complementary service providers to be very helpful. For example - need pitch coaching? I’ve now got a great referral list for that. Want help marketing your community, need someone to run an event, or want support for ongoing post-investment updates? I’m working on partners for all those.

Weekly Links: 3 Things Worth Clicking

1. The latest YC request for startups is live with 20 fascinating categories (link)🚀

2. A super simple multi-round cap table dilution analysis tool (link)📊

3. How they make 1/3 of the cardboard in America (link)📦

Thanks for reading, have a great week.

-Andrew

If you enjoyed this post, please share it with a friend, colleague, or anyone else who may benefit.

P.S. - I recently finished creating The Angel Network Toolkit: 90 Resources for Cultivating a Thriving Community of Pre-Series B Investors, and I’m sharing it with anyone who refers a friend.

How did I do this week?

👏😄Fantastic

🤷‍♀️😐Okay

👎😖Not great

About Me

I cultivate flourishing.

I'm also the CEO of PitchFact, where our mission is to cultivate flourishing specifically through efficient and collaborative early-stage diligence. I'm a proud husband, grateful father, and honest friend. My love languages include brisket, bourbon, and espresso.