Lately been noticing some strange cap tables in the early stage startup community – where angels own a fair amount of the company. There are so many ways to finance a company – most folks prefer equity or priced rounds. I tend to agree providing that all parties involved know what they are doing.

In some cases the startups are young and not very experienced. At the same time the angels are the same or potentially expecting to own too much of the company. Both of these combos can cause trouble.

First thing I tell all parties is get educated – start with Venture Deals for example.

Or read up from lots of different angles :: http://avc.com/2011/07/financing-options-convertible-debt/.

But when it comes to notes you will see some pretty harsh and normally valid opinions :: https://bothsidesofthetable.com/the-truth-about-convertible-debt-at-startups-and-the-hidden-terms-you-didn-t-understand-9fccf6854dee

More from Fred :: http://avc.com/2017/03/convertible-and-safe-notes/

Even our local VC weighs in : https://grayscale.vc/pesky-little-creatures-called-notes-1eedb65ed2ad

I am all for doing equity rounds if everyone knows what they are doing but I think a note might work in an early angel round when folks don’t know how to pull all the pieces together in a reasonable way. I would much rather see a note with a cap and decent terms that to see an angel owning 40% of the company for an early round.

I was looking around for someone who might explain this better and came across this from Index Ventures :: https://www.indexventures.com/blog/a-letter-to-german-entrepreneurs:

It is not uncommon for us to come across a one-year old startup that has yet to release its product, in which the angel investors already own 60% of the company, three founders (together) own 40% and there is no option pool. While the company may be interesting to us from a product, market and team perspective, we know that we will face massive challenges in structuring an investment that will result in a company with a healthy cap table that will allow the company to grow, attract and retain talent as well as raise future rounds of funding – without having to waste energy on dealing with misaligned stakeholders.

Spot on.

Why?

Angel investors, friends and family, who contributed cash to get the business started, deserve some level of ownership; but clearly 60% (or even 40%) are out of the question, if we want the math to work. For any founder, this type of structure should ring all kinds of alarm bells.

If we assume that the Series A investor will own 20% after the round closes, there is a 20% unallocated option pool and the founders and team own 40%, this leaves 20% for the earlier investors after the round. We should also note that when a startup raises a large Series A round that may involve two or three venture funds, the amount of equity allocated to the round might be as high as 40%.

Founders also don’t think about future rounds and the problems that can steamroll:

This problem is all the more thorny, when the angel investors have the right to participate in future rounds and intend to do so in order to protect against dilution. In these cases, the equation is basically unsolvable and doing a round with a venture investor risks entangling the founders in endless meetings and conference calls with their angel backers to find a compromise that will allow them essentially to rewrite their cap table.

I keep hearing folks suggest this solution but this is not a good answer:

And while having the angel investors sell all or some of their shares to the new investor might help redress the cap table, it is never desirable to have most of the money invested in an early round going to selling shareholders rather than into building the company.

This is great baseline advice:

Our advice to future entrepreneurs in Germany, and elsewhere, is to be thoughtful about the first money you raise; think hard how much you require, who you raise it from and what your investors are getting in return. While the people giving you your first €10,000 should be rewarded, they should not be given the means to hinder your future fundraising. While this advice may be perceived as self-serving coming from a venture capitalist keen to make Series A investments in Germany, we genuinely believe it is not and that you would hear the same thing from experienced entrepreneurs in the Bay Area or elsewhere.

This also makes a ton of sense:

We also think that in your seed round, you should raise as little money as possible – just enough to allow you to get to the validation point you will need to raise your next round. Choose your angels wisely and ask yourself how helpful and cooperative they will be when you come to raise your next round. We also don’t think that it’s a great idea to raise money from dozens of angels, if you can raise it from just a handful. Keeping them informed and getting them to agree to the terms of the next round should be as simple as possible and ideally not require lots of your (and your lawyer’s) time.

And this on corporate VC’s has some truth in it as well although your mileage may vary:

Finally, we generally don’t think it makes sense to include corporate investors or their venture arms in seed rounds. Having them be part of your cap table, with an investment that is probably trivial to them, will likely entail more negatives than positives. The real value that these partners can bring is through being great customers, great suppliers or a distribution partner. Further down the road it may make sense to bring one or more corporate investors into your ownership structure, or even sell the entire business to them, but until you reach that point, we think you are much better served by trying to do business with them all.

We, the people in the SEA ecosystem, need to help everyone improve.

I have a Discord group for VC and Tech going here :: https://discord.gg/sp3CckG

Please join in and let’s chat about it – another experiment I want to have is random audio meet ups to chat versus type.