Messed-up Cap Tables

Even the most well-intentioned founders often end up with a bad cap table. It wreaks havoc on everything from future fundraising to internal team dynamics.

I feel strongly about this topic & have been at its negative receiving end several times. Therefore, consciously dropping some harsh truth bombs in this post.

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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Founder vs Investor: both sides of the table

I was a VC in the really early part of my career, then became an operator+angel investor for several years, before founding Workomo. Here’s how my lens for looking at company-building has evolved from an investor then vs. founder now:

#1 Doing 0-to-1 is really hard — as an investor, I never truly realized how hard it is to “make something people want” from scratch & have someone care enough to try using what you have built. The struggles of building from 0 can only be truly understood when experienced first-hand.

#2 Appreciation for engineering talent — as an investor, while one understands the importance of quality developers, the focus tends to be more high-level in terms of looking at leadership (CTO/VPs). As a founder, I now feel gratitude when I work with top-tier functional engineers.

I have seen how a solid iOS engineer can save weeks of extra cash burn while delivering excellent output. Or how quality backend engineers are so hard to find. Or in a small engineering team, a developer with 20% better output can really move the needle via effort-compounding.

#3 Importance of iterations — as an investor, I don’t remember ever asking founders: “how many iterations did it take you to get here? And what did you learn?”. Perhaps, ‘cos I had never been a 0-to-1 founder, I focused more on “outcomes” and never on the “process”.

Now as a founder, my core operating philosophy revolves around 1) “lean” iterations, 2) systems-thinking & 3) agile dev. (hypothesize-build-get users-learn-iterate-repeat). When facing high failure rates & random outcomes, the only thing you can truly control is the process.

#4 Re-orienting from “speed” to “velocity” — a piece of frequent advice I gave as an investor was “do things at even more speed” or “how can we ship even quicker?” or “can we fundraise even sooner?”. It was missing one thing: “are we moving quickly enough IN the right direction?”.

Investors want quick results, whereas as a founder, you know building outstanding products takes time & thoughtfulness. Even if you ship quickly, building the wrong thing without pausing to learn, analyze & re-orient will result in no one using it.

#5 Design is not just UI/ UX, it’s end-to-end product experience — as an investor, my view of a portfolio company’s product was just limited to what “I could see” and what “I could use”. As a founder, I now think about “what the user will FEEL”, right from the landing page, down to repeat usage.

#6 Effective teams aren’t just about assembling the most talented — as an investor, one primarily looks for signals of talent (track record, pedigree, intelligence, expertise). As a founder, I now include commitment & fit in the hiring matrix. Sometimes even as a filter.

While “how can we hire an engineer from Google or FB” is a good question to discuss with investors, other high-impact questions that need focus include “how is the team morale?”, “how can we better reinforce the vision.” or “how is trust being built as a remote team?”.

#7 Limited value of startup playbooks — a common technique investors use to try and add value to the portfolio is sharing what other companies/ founders are doing, their approach, what seems to be working for them etc. I have been guilty of this as well.

While there is some merit to having market intel & learning from other founders’ experiences, you quickly realize as a founder that all so-called playbooks are biased, post-facto analysis & polished versions of reality. You gotta figure out your own unique way.

#8 Who is a co-founder? — when looking at co-founders in a team, the top things I would primarily evaluate as an investor: 1) do they have complementary skill sets (engg+product+biz)? and 2) will this team look good enough on a deck, to be able to raise the next round?

Now with the perspective of a founder, I evaluate many other facets in founding teams: 1) does this person have the same level of passion, desire & commitment to building this company?, 2) when sh*t hits the fan, will this person be last-person-standing, 3) how much can this person sacrifice to see things through till the end?

#9 “Closing” with no logos behind you is damn hard — with IDG Ventures or Alibaba behind me, all doors were open. I could reach anyone, get quick responses, and easily attract people to my projects. Made it easy for me to say to founders: “let’s close this deal” or “let’s hire this person”.

As a founder, I have now felt how hard it truly is to hire, close deals or close any opportunity for that matter, when you are trying to build an unproven company, on a vision that’s new & hard to visualize, with a product that keeps frequently changing & has no scale yet.

#10 Guarding your mental state is everything — startups are a mental game. All the awesome founder qualities that people talk about — grit, perseverance, belief, conviction, are all internal. Perhaps the biggest miss I had as an investor is not observing the mental state of founders.

This becomes especially challenging as founders like to put up a brave face in front of their investors. I now strongly believe that it’s the job of investors to look past this veil of confidence and help unshackle their true mental state. I regret not doing this the most.

Ultimately, investors become successful when they back the best founders, who then get lucky :). Similarly, founders improve their odds by having the best investors in their corner. Personally, it has been incredible to experience both worlds & realize how different they are.

PS: if you are curious about what I am building, Workomo is a Chrome extension that shows you everything important about people, just before you meet, right inside the browser. We are already in private beta — do check us out and sign-up to request access. #peopleinsights

Note: this article first appeared on the Workomo blog.

Importance of diversification in venture portfolios: R=n*p

Read an excellent article today by Clint Korver of @uluventures on the importance of diversification in venture portfolio construction. Sharing some key highlights that I found really interesting:

Venture returns (R) are driven by 2 main factors — # of investments in a fund (n) AND probability (p) of an investment being an outlier return-generator. [UPDATED] in discussions with a few readers, I realized that a 3rd factor, ownership % in the winners (o), is also a key determinant in eventual returns (this was missed out in the original referenced article). Therefore, have updated the equation to R=f(n, p, o). To optimize R, ’n’, ‘p’ AND ‘o’ need to be optimized for.
Excellent chart on “chance of an outlier” — x axis has # of investments vs y axis has chance of at least one outlier for a specific portfolio size. Successful VCs need at least one outlier to have a well performing fund.

3. Summary from the chart in below table — to quote “Even the Superstar investor, who is 50 percent better than the top tier VCs, only has a coin flip of a chance of an outlier with a small, concentrated portfolio of only 10 companies.”

4. Interesting that @uluventures has chosen 50 as optimal portfolio size. This is really big, given just 2 investment partners. Strictly by data, assuming they are “top-tier” in terms of picking ability, they believe they have 90% prob. of having at least one portfolio outlier.

5. While 50 is still a huge portfolio, given failure rate of companies, incoming follow-on investors as well as organically graduating to the next stage, @uluventures can still smartly manage their workloads. This has been my experience as well at Operators Studio.

6. Whatever your “picking ability” might be, it’s just a smart choice for any venture fund to adequately diversify. While large firms do it organically by having multiple investment partners to do a sizable # of deals, smaller venture teams would need to do it more consciously.

7. Side-note: loved the reference to @AlignedPartners and their strategy of taking relatively lower risk profile bets (capital efficient, less dependency on external capital, more ownerships for everyone on exit). Resonated a lot with my approach for Operators Studio.

Overall, am a believer in thesis-driven diversification that is done consciously and thoughtfully, especially at the angel and seed stage (where I operate). Of course, if a venture investor can marry diversification (n) with top-notch picking-ability (p), [UPDATED] as well as maintain high ‘o’ in the winners by doubling-down on them, magic happens!

[UPDATED] Remember the brain tattoo R=f(n, p, o)

Would love to hear your thoughts and experiences on diversification of early stage venture portfolios. Are you a believer in diversification? Or do you focus on “being focused”? When does diversification become “spray-and-pray”? How should an angel/ seed investor go about balancing ’n’, ‘p’ and ‘o’ simultaneously?

Source: Picking winners is a myth, but the PowerLaw is not

Welcome Nishant Gairola to the Operators Studio team

Am super-pumped to welcome Nishant Gairola to the Operators Studio team, as a Student Associate. He is currently pursuing his MBA at IESE Business School in Barcelona, and has been a serial founder for a decade, building multiple companies from grounds-up.

Nishant will support me across core investing tracks for Operators Studio, including ramping-up deal flow, evaluating interesting investment opportunities and supporting current portfolio companies on their most pressing challenges. Nishant and I will also work together to further refine OS positioning, value proposition & differentiation in the global angel/ seed investing space, including cross-border themes. Finally, with his presence in Spain, OS will now have access to the European market, in addition to my deep US-China-India networks. I am particularly excited to explore Eastern European markets, as I have met some special engineering & founder talent from there over the last year.

Excited to be adding such high-quality young talent to the Operators Studio journey. If you are a founder, investor or any professional from the venture ecosystem looking to collaborate with Operators Studio, especially in Europe, please feel free to reach out to Nishant!