Capital shares are an incentive, bargaining leverage, and strategic asset for startup founders. What are the main mistakes to avoid in the pre-seed and early stages when dealing with investors and among founders? Let’s start with the Cap Table, which is the allocation of shares among a company’s shareholders, including their percentages and values.
While managing a Cap Table in the initial phase may seem straightforward, it can become increasingly complex as time goes by. The variables to monitor increase along with the number of shareholders.
To illustrate, let’s look at the legitimacy of anti-dilution statutory clauses for both S.p.A. and S.r.l. in Italy (Articles 2346, paragraph 4, and 2468, paragraph 2, of the Italian Civil Code).
It has become standard practice in Venture Capital operations to include an anti-dilution statutory clause that assigns a certain number of shares or units, free of charge, to a specific shareholder (usually the first investor/Venture Capitalist), even if the shareholder does not participate in the capital increase.
The clause aims to prevent the minority shareholder from being diluted if future paid capital increases are approved based on a lower company valuation than the one used for the minority shareholder’s investment. The minority shareholder can be protected from percentage dilution by the right of the option clause, which allows them to subscribe to any future capital increases before the shares or units are offered to third parties.
In investment operations through capital increases reserved for third-party investors, it is therefore essential to carefully negotiate this type of clause in order to enable all parties, especially the founders, to protect their different interests adequately.
Managing shares (both one’s own and those of shareholders) during fundraising, especially in pre-seed rounds, is one of the most delicate activities for any entrepreneur and can expose the founders to various risks. Here are some tips to avoid missteps:
- Consult a lawyer during the drafting of the company’s bylaws and shareholders’ agreement. This will help, among other things, to:
- Define guidelines for including a trial period for new founders;
- Include a vesting program, essential for startup equity compensation plans. Vesting protects company shareholders when a third party becomes a shareholder by stipulating that shares are earned based on the actual years of work in the company;
- Define clauses for employees and founders regarding leaving the company, defining good leaver/bad leaver, and considering how to use them to motivate your collaborators.
- Do not give too much equity to inactive founders. In pre-seed, founders should have at least 80% of the shares. In the early stages of a startup’s life, it may happen that founders dilute too much equity too soon with respect to the first investors. The consequence is that with significantly fewer shares, founders could lose a good deal of the interest and motivation that a startup requires in its early years.
- Include an Employee Stock Ownership Plan (ESOP) from the seed round. The plan provides for the assignment of a certain percentage of the company’s shares to eligible employees. If a “vesting” period is not completed, the company repurchases the shares for further distribution to other employees upon their departure from the company.
- Do not grant shares in exchange for services unless it is strictly necessary and possible jointly with a monetary investment. Otherwise, all the risk is on the startup, which is immediately diluted in exchange for future services that are often unclear and unmeasurable. Furthermore, additional rounds may be precluded for reasons similar to those described above for “inactive founders.”
- If there are two or more co-founders – and one of them owns 80% – usually something is not working. As I said, the startup’s shares are the main strategic asset for the founders, the more they consider the share distribution fair, the higher their motivation to give their best will remain high, and they will be committed to working in the startup.
- Always work with a Fully Diluted Cap Table and consider using a Dynamic Cap Table as a tool to understand dilution dynamics: this allows you to have not only the “snapshot” of the shares currently held by the partners, but you will have a complete plan of how the entire shares would be distributed if all conversions were triggered at that time.
Raising a Pre-Seed or a Seed round in Italy is hard, for this reason, we at Startup Wise Guys conducted a study to better understand the status of startup fundraising in Italy. We conducted this analysis through a survey, where we asked quantitative and qualitative questions regarding the pitch deck, Pre-Seed, and Seed stage to understand better the bottlenecks and the best practices of the fundraising process.
You can read in depth the results of our analysis in the report “Raising Capital in Italy: an insider’s guide to Pre-Seed and Seed Funding”.