- Only accredited investors should be on the cap table except management.
- SPVs are not allowed in Regulation Crowdfunding, this is one reason we, as ACG or the Alliance, do not seek crowdfunded companies for investment.
- Every investor in a company believes he had the right to walk in and demand the CEO’s time, which is to say, as an investor, you want the CEO focused on selling products and services, not on investors. So, it is in the best interest of the comapny and the management team’s time to be efficient with the number of investors on the cap table.
What investors should be looking for on a company’s cap table:
- Clean cap table free of errors and compliant with best management practices (enough common shares to cover the fully diluted position of the investors, debt holders, options, warrants, etc.)
- Low number of meaningful investors. If you find many small investors on the cap table, it is a signal that the founders do not understand the challenges they will face if they are successful in growing the company and seek later, larger, professional rounds of capital.
- If there are TOO many investors on the cap table, the company runs the risk of tripping over mandatory conversion thresholds forcing them to become a public company. This was once 300 shareholders, but it has since been amended to 3500 with the advent of equity-based crowdfunding.
- When a venture seeks a large, professional round of capita, each and every investor will be scrutinized as a risk. Professional investors are leery of small investors becoming squeaky wheels, rescission rights, etc. This is most pronounced as the company escapes the growth stage and begins scaling requiring larger rounds of capital.
Pros of the SPV:
- An SPV insulates the investors from mistakes of the company providing additional legal liability protection.
- Allows many investors to aggregate larger capital amounts having more “voice” (i.e. votes on company business).
- SPV’s are easier to manage having only one signature for company business.
- They are Better for the company – fewer numbers of investors with larger amounts of capital are more likely to be accepted by later investors, especially institutional investors.
Cons of the SPV:
* There is a cost, either setup and manage the SPV * Can’t take advantage of certain tax breaks. For instance, the State of Tennessee has a tax incentive for its residents to invest in startups, but they can only do so through direct investment, not through an SPV. * Investors can lose direct touch with companies unless they have a good communication system for updates and feedback. * Regarding votes of the membership of the SPV, 51% ownership of the entity typically controls the vote of the entity. So, make sure you are in and SPV with investors you know and trust. * In the ACG/Alliance model, it allows funds and individuals (side-car investments) to invest together and to seamlessly manage these investments.
Pass through or C-corp?
* A pass-through (LLC) allows you to report gains and losses on personal taxes. These are nice when the company is losing money in its earliest stages, but can be problematic when the company begins to make money, but not enough to return capital to investors. * C-corporation SPV’s can be subject to double taxation depending on how an acquisition is executed. It is possible that the company will have to declare capital as profit before it can be returned as a dividend.
The short version is savvy investors like the additional liability protection, ease of management, and protection from later stage investors, and the ability to aggregate capital to hold a larger “chunk” of the company. So, most professional investors use some kind of SPV for investing.
For more information:
- Startup Grind: 4 Things Investors Secretly Look for in your Cap Table
- AlleyWatch: The Importance of a Clean Cap Table for Investors
- SeedCamp: Investment – Are you in Danger of Raising a Toxic Round
- Wolverine Startup Law: Beware the Cap Table
- Cap Share:10 Cap Table Mistakes that could Cost you Money
- Calc Counsel Group: Startup Stock Ownership – Don’t let your Cap Table become a Crap Table
This is published under the Appalachian Regional Commission POWER Grant, PW-1835-M.
Copyright Appalachian Investors Alliance, Inc. 2018
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