You have a great idea, you’ve developed a prototype product, you’ve done customer discovery, and you’ve assembled an awesome management team – congratulations! Now you need outside funding to continue product development, build out the sales team, etc. I often see early stage companies waste time and money because they are unfamiliar with the process of raising money or with the mindset of investors. With that in mind, in this and future blogs I will address frequent mistakes that companies make when pursuing funding, and how to avoid them.
One common mistake is the inability of the company to provide potential investors with a proper capitalization table (better known as a cap table), or in extreme cases the inability to even provide a cap table at all. A cap table is a list of the equity owners of the company (whether a C corp, S corp or LLC), and the exact ownership percentages of each individual equity holder. This is one of the key pieces of information that a potential investor will request early in due diligence.
Sounds simple to put together, right? In many cases, not so! Early stage companies are usually cash-poor and often grant equity in the company to employees and other service providers in exchange for services. Examples include product development, marketing assistance, etc. However, these agreements are often done on a handshake or by exchange of emails rather than formal documents. Even when there is some sort of written agreement, it is often prepared internally without the involvement of legal counsel, resulting in deficiencies from a legal point of view.
Disputes often occur from these informal arrangements. A typical scenario is that the service provider believes they have done their part and are entitled to their shares, but the company believes the services were incomplete, poorly done, or something else is unfulfilled. If the company thinks that the service provider has not held up their end of the deal, and therefore entitled only to part or none of the promised equity, a legal battle may ensue.
Other complications include lost records or difficulty in contacting people who have moved, cannot be located, etc. In addition, once a service provider’s work is done or already well underway, it can be a tough sell to get anyone to sign the necessary documents; at that point there is little or no motivation for them to do so.
Lack of clarity as to exactly who the company owners are, the ownership percentages, or other disagreements results in major difficulties in clearing up the situation. The movie The Social Network illustrates how lack of clarity in this area can cause years of aggravating and expensive litigation.
Confusion in this area is one of the most obvious red flags for a potential investor. Investors need certainty regarding who the shareholders are and the ownership percentages for each person or entity. The saying “no one wants to buy a lawsuit” is especially true here.
The easy way to avoid this problem is to grant equity in your company only under written agreements (no hand-shake or email deals!) that have been properly reviewed by legal counsel experienced in this area. When done at the front end, this is a relatively simple matter to address. When the company waits until funding is imminent, problems invariably arise. This scenario is a classic case of “an ounce of prevention is worth a pound of cure.” Do it correctly at the outset, and you will save yourself a lot of time and money in the long run, not to mention also greatly increase your ability to successfully attract investors.