Startup CEOs Should Test Strength of Cap Table Every ~6 Months To Know Where They Stand
I really liked Jason Lemkin’s “Do You Have a Weak Investor Syndicate” blog post from earlier in the summer. Go read it and then come back here….
Ok, so there are two different types of ‘weakness’ that Lemkin mentions — one has to do with lack of credibility in your cap table (“Can’t Bring You Good Leads For The Next Round”) which I’ll generally lump into the bucket of ‘you have B-tier investors.’ I’m not going to address this issue here because I think it’s largely a binary attribute of an investor and not as often situational — “punching above the weight of your cap table as a CEO” would be a good post, but separate from the point I want to stress.
Instead I want to focus on Jason’s discussion of bridges and pro rata, because it’s an area which is dynamic in every deal and often misunderstood by founders. Let me do some basic level-setting of how it typically works in a venture deal:
- A venture fund invests an amount of money into a round. I give you $1m for 10% ownership (to make the math simple). And I probably also have pro rata which simply means the right (but not obligation) to put more capital into your next round equal to my current ownership. If your next round is $10m, and I still own 10% of your company, I would maintain the ability to do $1m of your $10m round.
- As a venture fund I might have a strategy which says “for every dollar I invest into companies, I will hold one dollar in reserve for additional financings.” If I have a $100m fund, $50m into initial investments and $50m into follow on. Each fund has its own strategy about reserves, follow on and so forth. There’s no industry standard other than most large multistage firms will be interested in pro rata for their successful companies.
- Now here’s where it gets complicated: follow on decisions are highly dynamic. Reserves are fluid concepts based on what companies are coming up for funding when, how they’re doing at the time, the size/stage/terms of the round and so on. No founder should assume their pro rata from insiders is in the bag, let alone a bridge check, only because the cost of being wrong (to the company) is so high. 99.9% of venture funds do not have enough capital to do their full pro rata in every investment for every round subsequent to their initial commitment.
Jason suggests asking direct questions like:
And I agree, those are great questions. The one point I want to emphasize is don’t ask these just when you’re closing the initial round or actively fund raising the next. Instead my recommendation is to ask every ~6 months or so in-between financings. Have a real discussion 1:1 with your major investors about how they’re thinking about this investment.
If you’re on-track to the next financing, you can couch it as “hey, as I start to think about the next round — and knowing sometimes preemptive rounds can happen these days — I want to check in on how you’re thinking about us. If you had opportunity to buy up, would you want to? If I can make sure you have your full pro rata available would you take it? If we’ve got an oversupply of demand, is this the round your firm usually starts stepping back from pro rata?”
If you’re not yet on-track, then it’s a variety of “hey, per our operating plan, I think we can get to the next round milestones but, so I have this in pocket, how does your firm think about inside rounds, especially if we want to raise a little more from current investors to get even further before going to market.”
Healthy founder <> VC relationships should always have open discussions about capital. One way I like to do it to be clear when I’m putting my “Homebrew” hat on versus just advising the company what’s best for them. I’ll give you an example of a conversation I had with a current portfolio company just this week.
It’s a seed stage company that has demand from insiders and new investors to do a ‘top-off’ in order to delay going out for a Series A. Since things are going well, our collective belief is that a few more milestones will be rewarded by the market, so let’s push further. I gave them an offer to do super pro rata at a post money of X (where X is above the seed round post money we previously led) while also offering to do ‘just’ our pro rata if they price above X (since there’s momentum from others to do the round ~10–20% higher than X). When we were talking it through I emphasized that the difference in check size I’d write had nothing to do with difference in confidence in the company or commitment to them as people (we already own close to 15% of the company as their largest outside investor). And I told them, they should probably do the higher price round even if it meant a ‘worse’ deal for us! Why? Because it’s better for the company overall IMO. I rather see the difference in dilution be used to continue hiring amazing team members going forward than add a few more basis points to my ownership. Long term greedy!!!! Now I’m just waiting for confirmation on what they want to do 🙂
Every situation is specific to the company, the investor and the moment in time. I’m sure there are examples where I needed to play ‘hardball’ or provide less flexibility in optionality, but I think it just goes to show that the best outcomes come from real discussions.
Lastly, Jason has a single very practical suggestion on what to do if your cap table is tapped out. I’m not going to repeat it here because you should give him the click 🙂
Thanks Jason for writing one of the posts I know I’ll be sharing with founders!
 Some situational examples do occur though: when a firm (or more specifically a GP at a firm) is rising or falling in stature; when a firm is investing in an industry outside of its wheelhouse and lacks relationships with appropriate downstream investors for the company.