What Is A Toxic Cap Table And How Can It Destroy Your Startup?
A toxic cap table, also known as a toxic round, is a fundraising round that can pre-dispose a startup to struggle to find subsequent financing from other investors.
It happens when the founders of a startup cede more ownership or shareholding than they should have done to seed investors, leaving the founders with little control of the business.
While a company may be doing well, customers love your product and it’s growing like crazy, investors may shy away if the ownership structure or capitalization table is “broken.”
A broken ownership structure can disincentivize a founder from performing at his or her peak or make important strategic decisions extremely difficult to execute.
A toxic round could happen when “too much money” comes in too early at too low of a valuation, or when a company is too undervalued, or all three.
While this may not be the case in the day-to-day running of the company, it poses a risk to any other new investors looking to come in later.
There are several reasons why investors may stay away from a startup that experienced a toxic round in the past. These include:
- There’s a high likelihood that the founder will be less motivated to stick with the company once it raises more capital in the future since the founder’s equity value would decline and get diluted further.
- A large ownership by the initial investors could also point to a problem with the governance structure of the startup.
- It raises questions and doubt for the new investors as to how the founders got into this situation. Did it happen through a down round? Was it due to other negative circumstances that could affect the future of a new investment?
- The investors could also see the fundraising as a case of the seed investors looking to dump their shares to a “greater fool” as they exit.
For technology sector startups, there are already clusters of “ideal” cap tables that have been set with a plus or minus 10-percent wiggle room. The farther you get from this setup, the harder it becomes to attract investors for a tech startup.
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