Cap Table and the Dilution of Founders on the Venture Capital track
Photo by Austin Ban on Unsplash
My first post on the Astella blog is about cap table, a hot topic discussed internally here, within the Astella team, and a critical factor in startup investment analysis. The purpose of this text is to share how we view the importance of this subject for investors and especially for Startup founders who are looking for financing via Venture Capital.
One of the most crucial concepts for founders looking for Venture Capital investments is “stage financing.” This financing model foresees that there is a goal - or milestone - to be achieved at each stage of a Startup and that each milestone will need a whole world of capital to reach this goal. Derived from this, there is a rule for dilution and valuation in each round.
In recent years, there has been an increase in the volume of capital invested in startups in Brazil, as well as more information on cases of successful companies and a greater understanding about the incentives for the founding team and cap table. That said, savvy and experienced investors understand the importance of having a favorable cap table for subsequent rounds and one that encourages founders and their teams to generate value for the business.
According to a comprehensive study by Capshare, which analyzed over 10,000 cap tables of companies financed by Venture Capital, the first conclusion is that the average dilution per round is predictable. Analyzing the information from the shareholding structures, we can see that it takes between three to four rounds for entrepreneurs to no longer have shareholding control of the company:
Other conclusions of the study worth mentioning include:
- Series-A and Series-B stages are where the most dilutions occur.
- In each round, 10-13% of the company's treasury shares are reserved for stock option plans for key employees.
- At the Series-D stage, it is expected that shares will be divided into:
- Founding team with 11-17%
- Team of key employees with 17-21%
- Investors with 64-68%
Along with the cap table's evolution and new rounds, the company is expected to accumulate added value. The image below shows the evolution of the Pre-money valuation from the same study.
Another study from Blossom Street Ventures shows that each individual founder of a company financed by VC in the United States had, on average, a 9% share of their companies at the time of IPO. Regardless of the low percentage value, the market value of this participation is high with each founder leaving with an average equity totaling US$ 269 million. Another relevant stat is that it takes large tech companies an average of 9 years for the exit via IPO.
When Dilution Generates Value
In the journey of Venture Capital, it is certain that the founders will suffer the greatest dilution in a startup's cap table. The important thing is that it occurs in a healthy manner, aligned with all of the partners' interests and, above all, that it encourages the founders to transform the company into a big business, thus providing appreciation on equity. In order for the incentives to make sense to the founders, the expected value of their participation in the next rounds must be aligned with their opportunity cost to dedicate themselves to this journey for years to come.
Below, using the cap table and valuation metrics from the Capshare Study, on the value of the participation of the founders, from the Seed stage to Series-C, for example:
In addition to the relationship between valuation and size of the round, it is important to remember that there are other factors and terms that influence the dilution and rights to shareholding of the partners that should be paid great attention, such as: Liquidity Preferences, Participation Rights, Conversion Rates, Anti-dilution, etc…
According to Astella's thesis, the ideal point to invest is the Seed/Pre-Series-A stage, when the company already has clear signs of Product-market fit (PMF), when it is thus possible to measure the capital efficiency of investing in sales and growth. Up until the previous moment, which we call Pre-seed, we believe that on average it takes at least $500,000 and a year or two to achieve PMF. At this moment, the ideal is for the founders to hold at least 75% of the company's stake.
So, in the next stage, after the Seed/Pre-Series A investment, the ideal is for the founders and their team to own at least 60% of their company, similar to the figures in the Capshare study.
Resetting an Unfavorable Cap Table
We often come across companies with a cap table outside these parameters, which we call an 'unfavorable' cap table for the Venture Capital route.
Some of the most common reasons that this occurs are:
- Cash burn was not able to find the right model for product management and go-to-market
- Pivot or readjustment of the business model in which a new early stage round is needed to develop a new market or product
- Previous rounds that were non-standard in terms of dilution of the entrepreneurial team
In this way, and if the entrepreneur still wants to seek funding through Venture Capital, our suggestion is for the entrepreneur to recapitalize his or her membership.
Usually this involves reallocating part of the equity of investors from previous rounds to the founding team. This readjustment is seen as a way to give entrepreneurs 'a second wind' to keep climbing the mountain.
Our first suggestion is to simply reallocate or assign the participation to the founders to adapt a cap table in a manner that is favorable to the Venture Capital route.
Or another way, which depends on greater structuring, would be to issue treasury shares, which will belong to the company and, as the entrepreneur advances to other stages, he or she receives these shares.
Correcting problems with other aspects of the startup such as product, sales and hiring talent stress the business in a positive way and they give way to solutions that move the business forward. On the other hand, problems with cap table hold the startup back. Ideally for early stage investors and entrepreneurs, they already have an understanding of stage-financing and dilution, and present themselves to the funds for potential next rounds with a balanced and favorable membership to come.
Thanks to the Astella team for proofreading and feedback on the article.