Topic of the Week: Cap Tables
Andrew Goldner here. With Danielle busy increasing our population by one (congrats, Danielle!), I’ve stepped in with a guest post. I’m a Founding Partner of GrowthX, a Silicon Valley seed-stage venture capital fund.
At GrowthX, we believe founders shouldn’t have to leave their homes to build great companies. That’s why we’re investing heavily outside of Silicon Valley.
I arrived in Tennessee in search of great founders and, in the process, I fell in love with the hopefulness, faithfulness and happiness of Nashville. I packed up in Palo Alto and moved here with my wife and two daughters in July of last year. (Here’s a short video that the State produced featuring GrowthX and why we chose Tennessee.)
As I travel throughout the United States and emerging markets globally meeting with founders, co-funders, accelerators, universities and policy makers, I’ve noticed common trends among developing startup ecosystems.
One example of a common trend is the odd goal of becoming the “Silicon Valley of ______,” rather than playing to the unique strengths of the community or region, such as access to a large base of customers concentrated in one or a few industries.
Tennessee has done a great job of avoiding this trend and charting our own course playing to the strengths of our great state (e.g., health tech, logistics and additive manufacturing, to name a few).
Another common trend is part of a larger narrative that is leaking out of Silicon Valley where certain entrepreneurs are being branded with a second-class citizen status. Only in Silicon Valley is “lifestyle business” a pejorative term!
I was raised in Cleveland, Ohio, where turning an idea into a company with $10,000,000 of annual revenue created wealth for your family and generated respect from the community. In Silicon Valley they have a word for that: FAILURE.
This makes sense in Silicon Valley, a tiny stretch of land that, amazingly, accounts for nearly 50% of all venture capital globally. The closest second – at only 11% – is the New York City metropolitan area. Venture Capital is “big, fast capital.” Silicon Valley owns venture capital, but they do not – and we should not let them – own entrepreneurism.
To me, an entrepreneur is someone who takes the risk to own their own store rather than working as an employee in someone else’s store. But, that doesn’t necessarily mean also wanting to grow that business from one store to fourteen stores across nine states and three countries in two years!
That’s a venture capable entrepreneur, and venture capital is designed to help that entrepreneur grow their business very large, very fast. (For context, GrowthX only invests where we see a serviceable addressable market of at least $10B and seed-to-exit velocity of ~7 years.)
We should continue to marshal public and private resources to proudly support all entrepreneurs – small business owners and unicorns alike. We should be careful not to mimic Silicon Valley where the leading startup success metrics are amount of money raised and valuation.
We need to teach our founders that the best source of capital is from customers – they don’t take equity or a board seat and they only want you to help them. We can do better than Silicon Valley where accelerators are busy teaching founders how to build products and raise money; we can focus our mentorship and statewide programming on helping founders market their product and make money.
Equally important, for founders that want to build the proverbial rocketship, let’s help set them up for success to raise venture capital. It’s a unique asset class with non-obvious characteristics, such as stage-relevant ownership profiles (i.e., how much a founder should own, how much a funder needs to buy, etc.).
That leads me to one final trend to share today: cap table mismanagement.
This issue alone can disqualify a founder from raising venture capital in any of the three most prominent venture capital metropolitan areas – Silicon Valley, NYC and Boston – that collectively control nearly 65% of all venture capital investments globally.
Venture capitalists assume from the outset that venture capable entrepreneurs will create several series of preferred equity across multiple rounds of financing. I joke that “A” has become the fifth letter of the alphabet in venture capital. Founders raise a friends-and-family round, Angel round, pre-seed round and seed round before raising a Series A. Creating a Series Seed of preferred equity is now common, and I predict we’ll see a Series Pre-Seed in the near future.
Founders need to protect their cap table from day one. That means only using equity in rare instances and never when cash can and should suffice.
It also means being thoughtful when creating a board of advisors and only granting them equity in line with current best practices (i.e., 0.5% to 1.25% equity subject to vesting).
Founders and funders need to partner together to protect founder equity, starting with the first round of financing, to ensure founders retain enough equity to sell through multiple rounds of additional financings, while retaining enough ownership to stay focused and motivated and to meaningfully share in the wealth creation of a liquidity event.
Cap tables only have three buckets into which ownership is sorted: the founder pool, the funder pool, and the option pool. Venture capitalists across each series of investment adhere to commonly accepted ratios of ownership across these three buckets.
For example, Series A investors typically look for a 25% post-money ownership stake, a pre-money option pool of 10-15% and a post-money founder pool of 50%.
Selling too much equity at the seed stage (or earlier) – whether due to an unreasonably low valuation or raising too much capital (or both) – makes this ratio impossible without a recapitalization, an exercise that VCs are loath to be associated with. (Heads-up founders: a larger-than-standard option pool can be a backdoor to a lower valuation.)
Raising venture capital is like playing chess: founders and funders need to be contemplating the next two or three rounds of financing while negotiating terms of the current investment round.
Nashville has strong entrepreneurial DNA, dating back to our founding industries. We enjoy an abnormally high concentration of entrepreneurs that rivals, if not exceeds, Silicon Valley (though, here, they call themselves singers, songwriters or musicians).
We can continue to future-proof our economy by enabling statewide founders to build great companies here. That includes capitalizing them early with local sources of funding on terms that enable them to raise venture capital, leaving the option open to go big.
Nothing will propel our startup ecosystem faster and farther than growing local exit values. To do this, we need to continually understand the common trends and best-practices that are driving the socioeconomic impact of our startup ecosystem.