Hi, it's CJ Gustafson and welcome to Looking for Leverage.

My CFO friend Rick Smith wrote a novel with a CFO in it named Ezra. Ezra has a law he repeats on the first day of every new CFO job:

While he's a made-up guy at a made-up company, I've inherited enough cap tables with alligators in them to corroborate his claim. And unfortunately the moment you find out he's right is the worst possible one: when you're trying to sell the company.

You know how an equity waterfall works. It’s what the paying agent executes against at close, and you sign a rep in the purchase agreement warranting it's complete and accurate. When it isn't, the fix comes out of escrow, or out of the sponsor's proceeds. Much less fun phone call.

A few years back I was in the middle of exit prep and I had our option ledger open. Sitting on it was a batch of vested grants with exercise windows about to close. Some belonged to people who'd already left the company. A couple expiring grants belonged to tenured employees still with us. As far as I could tell, most of them had no idea the window was closing (it's not usually front of mind, especially if it's been multiple years), and obviously none of them knew we were selling.

So I did some math that didn't feel great. If I reminded these folks to exercise, they most likely would, and every exercised option dilutes everyone else in the waterfall: existing investors, management (including myself), and rank and file employees (current and former) who'd already exercised.

For better or worse, the answer that protected existing holders and honored the confidentiality I was bound to was to simply sit on my hands and let the windows run out.

I didn't love it then and I don't love it now.

The second scenario is even less straight forward.

We had an employee, still with us, who'd been told by our COO that he'd get a chunk of shares when he got promoted. He did indeed get promoted, and was a contributing member of the sale team. However, the shares never got papered. There was no board approval, no grant in the system, and no email correspondence I could even point to.

And to make matters worse, the COO who made the promise had since left. So I had a current, productive employee who believed he owned something, a departed executive who'd made the commitment, and not one document tying the two together (oh, and a CFO left holding the bag). Every cap table carries a few of these, calls made and then half-forgotten, sometimes by people who've since left.

And selling the company awakens the dead.

A lot of sponsor-owned businesses didn't start life as buyout targets. They were venture-backed companies that grew up, didn't make it to the public markets, and got bought by a PE firm instead. Which means the cap table your sponsor diligenced was already carrying a decade of VC-era leftovers. I'm talking about option grants to employees who left in 2016, a warrant the venture lender attached to a loan that was paid back in full and nobody remembers, friends-and-family “advisors” from the seed round, and a long string of promises made across three different CFOs over ten years.

Many times PE firms will take majority control, clearing out all the cartilage on the cap table. But in some instances they will allow existing shareholders to roll.

If it’s the latter, when PE steps into the VC's shadow and takes control of the company, diligence usually does run a tie-out, matching the cap table software against the executed grant agreements and board consents. That catches plenty. But at the same time, it can't catch an obligation nobody papered, because there's no document to tie out to, and by then the people who'd remember the conversation have scattered. So the sponsor buys the company, inherits whatever survived, and those sins of the past go dormant for the length of the hold.

My friend Maor Levran founded an equity management platform, Slice, which means he's seen the inside of a lot more cap tables than I have. When I asked him what actually goes wrong, he started somewhere I didn't expect: the pool math.

Companies track an option pool in three buckets:

When someone exercises and then sells those shares in a tender, the shares often stop getting tracked, but the pool keeps counting them. Now your fully diluted share count is overstated, and every price per share calculation built on top of it is off. One company he onboarded turned out to be missing 400,000 shares from prior rounds. They caught it just after closing a round and corrected it retroactively, which was inconvenient, but survivable. His estimate is that the same error found during M&A runs 15 to 20 times more expensive to fix.

Then, three to five years later, the sponsor sells, either to another sponsor or to a strategic buyer. And now the cap table has a second layer on top of the first:

Underneath all of it lurks the un-caught venture-era stuff from the company's first life.

And both layers need to get certified at once. Your dealing with a zombie ISO grant from 2016 and the un-cancelled PIU from the new structure you moved to last year.

The errors cluster in the same few spots:

These are all tracking and compliance gaps that compound until a buyer's diligence team forces them into the open.

The worst time to meet your cap table is sixty days into a sale process. So:

Wishing you a cap table that ties out on the first pass,

CJ

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