We decided to answer our readers’ cap table questions. To do so, we interviewed Howard Lubert, who has over three decades of experience in private equity. For the last ten years, he has led Keiretsu Forum Mid-Atlantic and South-East through record growth. Howard is well known within the angel investment and VC community as being an expert on Due Diligence and Term Sheets, which include Cap Tables.
See the questions and Howard’s answers below.
Question: A Cap Table is not a priority or something founders are thinking about when raising non-institutional early-stage funding. How do Angels and VCs propose to address this shortcoming?
Howard: “Most founders in early-stage companies may not even know what a Cap Table is, let alone its impact on the business. As early stage investors, we are sometimes amazed at the lack of thought or effort that founders and management teams have applied to this critical component! Simply put, a Cap Table details how much of the company each individual owns and shows the impact that future investors will have on existing shareholders. The impact comes as new investment money dilutes the ownership of everyone who came before them regarding their percentage of ownership. At Keiretsu Forum, we typically negotiate a Term Sheet as part of our Due Diligence efforts. During the diligence process, we work with the company to craft the appropriate Cap Table so that everyone understands their position before and after investment.
Question: What can a startup do about its Cap Table when it has a large number of individual investors from whom it has raised money before institutional investment?
Howard: “It amazes me that some founders and CEOs are obsessed with the size of their Cap Table and believe that this will be detrimental to raising ‘institutional funds’. First, everyone should know that you can have 2000 investors on your Cap Table before you have to consider an IPO. Second, and of note, less than 1% of all the companies who are able to raise funds from angel investors will ever see any investment from VCs or institutional investors – this according to research done and tracked over more than 20 years of tracking early-stage investments. Finally, and possibly most important, without the investments from angels and other investors the company would not be able to stay alive. Founders should welcome each and every investor to their Cap Table. At Keiretsu Forum, we started investing in Savara Pharma 9 years ago. Rob Neville, Savara’s Founder is famous for having raised more than $50 million from 400+ angels! Rob never spoke to VCs and was obviously successful in funding FDA clinical trials using our money.”
Question: What is the impact of equity crowdfunding models which are on the rise on the Cap Table, and challenges they present to institutional investors like VCs? This is not Kickstarter type crowdfunding where people pay in advance for product development. But rather true equity fundraising using crowdsource platforms or regulations.
Howard: “There are two flavors of equity crowdfunding, one accepts only accredited investors and the other allows almost anyone into a deal. Under SEC 506(c) companies can raise money through online services that cater to and take a cut of every investment. At Keiretsu Forum, we shy away from considering deals that have a crowdfunding history and most VCs are also wary of this direction. That said, under Regulation A, which is a mini IPO, companies can raise up to $75 million a year from the crowd.”
Question: How much are VCs familiar with Reg CF and Reg A equity funding models? How would VCs deal with a cap table where a startup has raised funding using Reg A or Reg CF provisions?
Howard: “I can’t speak for all VCs, but most are well versed on what is happening in our industry and where Reg A is for large investments. Reg CF (or Title III as it was originally named in Obama’s Jobs Act) allows a company to raise up to $5 million. Both Reg A and Reg CF are highly regulated, require the backing and direction of a licensed broker dealer and in some cases generate more expenses than investment money for the company. Once a company has successfully executed a Reg A deal there is no need to turn to VCs or other investment groups like ours. The best course is to go for another round the following year. In the case of a Reg CF, there is likely a large and cumbersome accounting burden that will, in my opinion, impact the interest of professional investors.”
Question: Do VC’s force changes in the cap table that will directly impact prior investors(angels, friends, and family). For example, forcing them to give up their equity or disproportionate dilution.
Howard: “This question makes me think “Vulture Capital” and it still does exist. There are bad apples in every barrel and private equity is no exception. That said, when we negotiate a Term Sheet and the resultant Cap Table, we are never trying to hurt the previous investors who obviously took greater risks by investing earlier than us. The assumption is that the previous investors wrote checks into the deal at a lower pre-money valuation than we are, i.e., they invested in the company with a pre-money valuation of $5 million and paid $1 per share for their stock. We structure our deal on a negotiated and validated pre-money of, say, $10 million and pay $2 a share. All the previous investors still have all their stock but control a smaller percentage of the company’s equity, but their stock just doubled in value by this latest round. And the smart investors will exercise their right to participate in the new round which allows them to maintain their original percentage ownership of the company.”
Thank you Howard for your insight on Cap Tables. If our readers have any further questions on Cap Tables or the startup funding process, please leave them in the comments below. We be doing a series of Q&A articles interviewing funding experts.
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