During my recent India trip, I was introduced to this amazing founding team building in the edtech space. Yes, I know! Byju’s and all. What can I say – I am a true contrarian.

This is a truly gritty team that’s been grinding in the space for several years (starting from their undergrad days at IIT) with minimal capital and seems to have now hit on a game-changing opportunity. They have signed a highly lucrative commercial contract, something that even massively funded companies in their space have been unable to crack.

This team is arguably the perfect example of the founder persona I believe in the most. In fact, these are the kinds of backstories I wait for. Intelligent founders with authentic passion for a large TAM, unique customer insights earned via frugal execution and strong leading signals of perseverance.

As I went through my investing checklist, this deal checked all boxes EXCEPT one. The one whose real importance I have learned only by burning my hands many times. In fact, this item is so important that I ultimately had to pass on investing in this startup because of it.

The deal-breaking reason is a messed-up cap table! Here’s the situation – with product-market-fit still being some distance away even after multiple iterations, the founders have already diluted 30%+ to 3 angel syndicates, even before an institutional round has been raised.

To add further pain, even the current round is being done at a relatively low valuation, mainly because of insufficient traction in the business as well as young founders lacking leverage in fundraising discussions. This round will make founder dilution even worse!

Based on my past experience with other portfolio companies, these highly diluted cap tables lead to 2 types of issues:

1/ External – follow-on VCs hate to see these type of cap tables. While they are themselves looking for 20-40% ownership in an institutional round, VCs also want to ensure founders have enough skin-in-the-game (equity ownership) to be incentivized to build the company for next 7-10 years. In addition to this, a 10-20% ESOP pool is also typically required to attract & retain talent.

Structuring an optimal cap table that balances the ownerships of founders, investors & employees requires having enough “space” in the cap table to begin with. Having a pre-PMF cap table where angels own 30-40% of the company leaves no room for this.

In fact, cap tables are such a big issue that I have seen financing rounds of my portfolio companies get nipped in the bud, even though the business itself was on a strong path.

It’s important to add another nuance here. In teams with multiple co-founders (3+), follow-on investors also care about the individual ownership of each founder. Especially, the ones considered “mission-critical” for the business (eg. the market-facing “CEO”, the one who has built the technology & is managing it “CTO”). Therefore, having large founding teams can add additional structuring risk to the cap table.

2/ Internal – messed-up cap tables don’t piss of just VCs. I have first-hand seen them creating internal issues amongst the founders, around misaligned incentives. A few real-world examples from my experience:

• 1 of the 3 founders is pulling much more weight compared to the other 2. As they start getting increasingly diluted in situations like above, resentment starts to surface regarding ownership % of specific individuals not accurately reflecting the value they are creating/ not creating. A zero-sum mindset sets in, where the % of the pie starts mattering more than the size of it.
• Because angels own a significant portion of the business as a block (often larger than each of the individual founders), they feel they can dictate how the business should be run operationally & start meddling in execution, creating unnecessary overhead for the founders.
• Because earlier rounds have been done at low valuations, both founders & existing angels go into a dilution-insensitive mindset. It manifests in many adverse ways including internal bridge rounds being done at relatively high dilutions, taking low prices for small external rounds etc.
• 1 of the 2 co-founders starts losing interest in the business (happens especially when fundraising has been hard). While this founder is checked-out & is just going through the motions, the person still doesn’t want to let go of any of his equity. This causes resentment in the other founder, who continues to believe in the business & wants to build it over the long term.

The excessive dilution scenario of the edtech startup is just one type of messed-up cap table I have seen in my investing career. Some other real examples include:

• Unbalanced ownership between founders – Eg. 2 so-called “co-founders”, one owns 80%, other owns 20%.
• The other extreme of unbalanced ownership, where an equal co-founder isn’t creating equal value. Eg. a close friend of the founders being given equal ownership, even though the person has no specific skillset or value-add to offer for the business.
• Non-operating co-founders with material ownership – Eg. someone who helped get the company off the ground, perhaps incubated it in some way, but has no operating role in the company. Yet, continues to hold founder-level equity.
• Too many non-institutional/ unsophisticated actors on the cap table – Eg. multiple angel networks, AngelList syndicates, individual angels & advisors crowding on the cap table.

I often get push back from founders that they can solve these cap table issues relatively easily. Some statements I hear:

• “[FOUNDER] We can find an investor to buy out all the angel networks on our cap table.”
• “[FOUNDER] I am already talking to XYZ to relinquish his balance equity”.
• “[FOUNDER] Having that non-operating founder on the cap table is not a big deal. He is willing to sell in the next round.”
• “[ANGEL NETWORK] If the company gets a term sheet from a VC, we will claw back some equity to the founders.”
• [FOUNDER] It doesn’t matter if angels own 40% of the company. Ultimately, the founders are running it.”

Time for some harsh truth bombs here:

Most VCs filter out startups with messed-up cap tables at the initial stage itself. Forget getting a term sheet, you are unlikely to even enter diligence.

Secondary deals are really hard to pull off, unless the fundraising market is red hot and/ or the business is hitting it out of the park.

Once any person or entity has equity in the company, it’s extremely hard to get them to give up even a small portion of it.

History is riddled with countless examples of large public & private companies where a person or entity with even a small % ownership will assert selfish authority during tough times & at key decision points.

To summarize, founders & early-stage investors need to be aware of cap table risks & their downstream impact on the company’s future. During any financing round, while it’s understandable that everyone’s top priority is survival & getting the cash to be able to live & fight another day, it’s also important to be strategic & think through the long-term consequences of the dilution being undertaken, as well as both the type & quantity of new actors entering the cap table.

Closing out with something I frequently tell founders on this topic – “Every time you are considering a new dilution on the cap table, think of it like getting a tattoo on the face. You have to live with its consequences every day going forward.”

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