Equity changes lives. While it may not be the lowest risk path to wealth, building something from nothing can be incredibly rewarding, both in personal satisfaction and financial outcomes. As barriers have dropped to building technology, the market is both much more competitive, and more lucrative.
For founders and early managers, the number one priority is to grow the business. Dialing in product market fit and getting to a scalable sales model are typically the top priorities, and for good reason. However, spending time on financial and legal items is often a necessary evil.
That said, just like many legal issues, there’s plenty that can go wrong related to a company’s cap table, and any of a variety of issues can cost a company significantly. I’ve seen cap table issues cause companies to fail to hire or keep key people. I’ve also seen cap table issues cause companies to fail to raise a new round or even to successfully complete an acquisition.
I want to walk you through the four most common issues we see on cap tables every day. I’d say that during the first year of a company’s life, I see at least one of these issues on about 80 percent of the companies I work with. I’ve also seen any one of these issues become so problematic that a company isn’t able to get around it and has to close its doors. These issues should be addressed as early as possible. It’s remarkable how much more people care about their ownership, and how much harder it is to make corrections, as the value of a company starts to increase exponentially.
The Importance of Vesting Schedules
The first pitfall to avoid is the lack of vesting. For anyone not fully versed in equity terminology, vesting ensures that an individual must do something in order to keep (or exercise) their shares.
Typically the vesting just stipulates that an individual must remain with the company for a certain amount of time. For example, if an individual is granted 10,000 shares that vest each year for 5 years, then that individual would gain the right to keep 2,000 shares a year, until the grant is fully vested after 5 years. If they left after 2 years, 6,000 shares would return to the company.
If a company fails to apply vesting to the scenario above, the individual could leave just after starting and would still retain their full ownership.
Many of the benefits to vesting are obvious, but I’d like to highlight several main benefits:
First, vesting retains top talent and incentivizes them to stick around and stay engaged until their shares are fully vested.
Second, for an early-stage company, investors are typically investing in the founders. They know the company may not have inherent value but they’re betting on your people. Vesting ensures that those people stick around, or if not, that a significant amount of equity opens up to bring in others. Vesting can help decrease risk and make a company more appealing to investors.
While most people get the value of vesting, they generally tend to exclude themselves when applying vesting. While founder vesting may not make sense when there’s only one founder, any time there are multiple founders, I strongly encourage the team to apply vesting to everyone. Here’s a scenario to show you how the lack of vesting can kill a company.
Three founders start a new AI tech venture and each owns 33 percent of the cap table, with no vesting schedules. After six months, two of the founders get in a disagreement and one leaves, still owning 33 percent of the cap table. The other two are left running the entire company, working until the early hours of the morning and struggling to get investors and new hires because 33 percent of the equity is locked up with the person who left. Assuming the company is able to raise money (many investors won’t touch a company with that much dead weight so early on), it will feel extremely painful 10 years later when the company exits to write a check to the founder who didn’t stick around.
Vesting is a simple way to prevent someone from leaving with a huge chunk of the cap table. When talking with founders, I’ll often point out that founder vesting can absolutely help, even for the founder who leaves. By vesting the stock, you dramatically increase your chances of succeeding should one of the founders leave. Owning a smaller portion of a successful company will always be more lucrative than owning a large portion of a failed entity.
The next pitfall surrounds non-papered promises. Non-papered promises are handshake agreements. Anytime you offer people equity in your company, you need to formalize the process with a binding, detailed agreement.
A majority of early-stage cap tables I have worked with have had some version of non-papered promises surrounding their equity. To be honest, we even had several at Capshare early on, despite working on equity full time.
Most of the time, companies don’t intend to create these. They usually creep in during situations like the following example:
John is running a brand new company focused on making widgets. He meets Margo at a widget conference and quickly thinks she would be an awesome sales hire. They meet later, and John asks if she could help him with several big contracts he’s trying to close. He mentions that he’d be willing to give her 2 – 3 percent of the company for her help and a cash commission for any deals she closes. They’re both excited about the prospect of working together.
Margo calls the next morning, excited about a call she just had with one of the companies. John had intended to formalize an offer, but things get going so fast and so well, that they never get around to it. However, over the next few months, not much progresses after the first few exciting meetings with the companies. John becomes frustrated with the way Margo splits her time between his company and a few other projects she’s working on. And Margo feels like John has the company going in too many directions to legitimately support the big clients he wanted to close.
I hear a version of this story at least once a month, and for at least some of those reading, I expect it hits fairly close to home. I want to take a minute to point out some of the main issues here:
- I see too many early founders giving away equity for help with no specific expectations set or conversation about what that help will look like. John’s offer didn’t specify that he needed the deals to close in order to give Margo the ownership, or that he needed her to work full time on his project or the duration for which she needed to work.
- By expressing his offer as a percent range, rather than a set number of shares, John left the door open on what specifically he was actually offering. Was the percentage 2 or 3 percent? Was that 2 percent at the time the offer was made or 2 percent at the time the shares were actually issued, potentially months later after a new round has been raised?
- By never formalizing the offer, there is a lot of legal exposure here. There are tax forms that need to be filed, and granting stock or stock options is officially done with an agreement signed by both parties that defines dozens of particulars.
These types of conversations happen regularly, and when you are discussing equity in broad strokes, sometimes adding context is necessary. It is also critical that verbal agreements are then quickly documented to ensure the particulars are agreed on by both groups and signed. It’s particularly important that those are put in place before work begins.
Reading through the example above, it’s easy to see that Margo is potentially on shaky ground to make a claim that she owns a portion of the company, but very similar non-papered promises have led to very public examples of individuals making millions and billions in subsequent liquidity events.
One common complaint I receive around this topic is that it’s too expensive to complete all of the legal work. Legal fees can definitely add up, especially early on when budgets are extremely tight, but ironically, it’s during that same early period when most of the worst and most costly mistakes are made.
Many law firms will defer fees for early-stage companies so that they can still provide excellent service upfront, and the company can pay when they’re in a better position to do so.
Maintain a Single, Official Cap Table
Here’s a familiar scenario for startups: the founders each have a copy of a cap table, the law firm has a copy too, so does the outsource CFO group they’ve been using, and their valuation firm.
So, which one is the right one? Competing equity records create problems. They exacerbate issues with documenting everything correctly and can cause different people at the company to make false promises based on bad and incomplete data.
I’ve seen a nine-figure acquisition fall through because of this issue. The acquirer wasn’t willing to stomach the liability. The concern was that cash distributions would be made based on their best guess as to the official cap table. They feared that after the acquisition, individuals whose claims were initially missed would come forward with lawsuits because they didn’t show up on the cap table version that was used. Ultimately the acquirer took a pass when they otherwise would have gone through with the transaction.
This pitfall has a simple solution – get out of spreadsheets. Using a spreadsheet to manage your cap table is the number one cause of competing equity records.
Know What You Don’t Know
As I said upfront, a founder’s job is to grow their business, and that usually doesn’t mean brushing up on equity compliance regulations. Founders don’t necessarily need to become experts in equity management, but they should know when to dig deeper and avoid a compliance problem down the line.
In this section, I wanted to flag a few potential compliance issues and their warning signs. My hope is that you come out of this section knowing better when to dig deeper.
- 83(b) election: When granting restricted common stock, employees have an important tax election they need to file within 30 days of that grant. This is an important due date for those employees, and the IRS is quite strict about the filing deadline.
- ASC 718: This is a US requirement to show an expense on your P&L for equity granted to employees. If you have employee equity and audited financials, or will soon, dig in and learn more about this requirement.
- Rule 701: Up to a point Rule 701 allows a company to grant equity and not tell the federal government about the grants. If you get anywhere close to granting 1 million dollars in equity a year make sure your law firm is on top of Rule 701.
- ISO 100k Limit: This is a bit of an oversimplification, but if a company is granting ISO option grants and gives an individual a grant that can be exercised for more than 100,000 dollars worth of stock, you should start researching so you can better understand the ISO 100k limit.
- 409A valuations: Your company should engage a firm to complete a 409A valuation prior to issuing stock options. The valuation is only used for tax purposes to set the strike price for the options, but a company can quickly get in trouble if they ignore this IRS regulation.
Complexity is Coming
Early-stage private company equity is different. Your cap table is smaller, and typically much simpler. You may have a few complexities on your cap table like convertible debt or restricted stock options, but during the earliest stages of your company, you have not begun to see the complexities that arise from venture-backed fundraising rounds, terminations involving equity grants or possible liquidity events.
Because of the simplicity of your equity during this time, stakeholders are more amiable to correcting mistakes, papering promises and clarifying details in ways that work for all parties, especially because the value of the company is still fairly nebulous.
My advice to early-stage companies is this – take some time now to dial in these potential equity issues. The problems, and therefore the work involved in fixing them, become exponentially more complicated as the company’s value increases. By spending some time now, expensive mistakes can be corrected or mitigated before they become true roadblocks for where you want to go in the future.