Please Stop Messing up the Cap Table
Angel Investors: have you seen this (or even done this)? A company you really like is raising a round. The company has set a minimum investment of $25,000. An angel is really bullish on the company but doesn’t want to meet the minimum. So, he asks the company to accept an investment of $10,000.
The poor entrepreneur; she’s in the midst of fund raising and it’s hard, capital is scarce. She needs money, so she, of course, says “sure.” And now there’s a small amount on the capitalization table. Once or twice is probably not a problem, but sometimes companies can end up with dozens of small investors.
Why is this a problem?
It costs time and money to keep track of investors. Who wants to bet that none of those investors over the years will change their address and not tell the company? Or that an investor wants to transfer his interest into a living trust. The more investors the company has, the more the company will spend to keep its records up to date.
Shareholders must from time-to-time vote. Most big shareholders do this when asked. But small shareholders seem frequently to ignore their proxy requests. If the company does not have a quorum, or sufficient votes to pass an important resolution, it has to chase down investors until it does. The longer and more complicated the cap table is, the bigger the pain this is for the company.
And depending upon the state of incorporation, minority shareholders may have rights
that can really mess up exits and changes to the capital structure. For example, in our
state of Idaho certain shareholder actions require 100% approval of the shareholders.
Other states provide dissention rights that allow a minority shareholder to opt out of an exit. Keeping the voting rights in the hands of knowledgeable investors and minimizing the potential for minority greenmail are additional reasons to consolidate small investors in an SPV
Professional investors may get nervous. If the company scales and attracts professional capital (i.e. private equity or venture capital), those professional investors may get nervous over a long list of small shareholders. Why? Small investors tend to gum up the works by asserting minority rights, not returning proxies promptly, or often include non-accredited investors. We have seen companies where a VC says before it will invest, the company must “clean up the cap table.” What this means is get the small investors off of the cap table.
It creates a potential exit liability. If the company is successful and goes into due diligence with a buyer, counsel for the acquirer will want comfort that all that stock was sold legally. If the cap table is filled with small investors, that may take time and money to comply.
Of course, this situation may be good for Loon Creek. A solution to a messy cap table may be to form an SPV and put all the small shareholders into the SPV. This works, but it costs money. And of course, the shareholders have to agree to this, or the company has to force them to accept it. And no entrepreneur really wants to be in a position of irritating her shareholders, even the small ones.
So, angels, don’t put the company in this position by asking the company to accept something smaller than the minimum investment. Either write a check to meet the minimum or consider forming an SPV with other small investors so that collectively you are one line on the cap table.
And entrepreneurs, no matter how tempting, don’t take on small investors individually. You may want to contract with Loon Creek to form an SPV to consolidate your small investors before they are on the cap table. We have worked with several companies who have done this most successfully. They contract with us to form an SPV, set their minimum and then simply send smaller investors to us. Thus, the entrepreneur gets her money, the investors participate at an amount they are comfortable with, and the cap table stays relatively clean.
Loon Creek specializes in syndicate formation and management services for private investors (and for the companies in which they invest). You can learn more about our services on our website.