I’ve heard it from founders- “I want more women and people of color on my cap table.” They usually say it with a look of despair either during a fundraising round or just after it when they realize that the vast majority of investors in their round all look the same. It’s frustrating to me too. Twice in one year I tried to put a small personal check as an accredited angel investor in the rounds of women founders who were raising a seed round, and I was told no because I couldn’t meet their investment minimums with my personal capital. The lack of diversity on cap tables is no surprise given the statistics about women and people of color in venture, but having worked with early stage companies for years, I know the same is true for most angel investors and family office investment managers as well.
Money that comes from diverse investors will often look different than money from typical funders, and we need more ways to welcome different-looking money to the cap table.
It’s a systemic problem with serious downstream implications. Diverse investors are less likely to have the same amount of wealth or to be in an institutional investment role, which makes it harder to make investments in startups. As a result, they don’t build a track record as an investor, and they don’t benefit from the wealth that is generated by those startups that succeed. Wealth and experience stay concentrated and inequality is perpetuated.
For founders who do care about adding diversity of their cap tables, they have a few options:
- Option 1: Spend a lot of time building relationships with diverse investors that can meet their round minimums, a strategy that may or may not lead to a more diverse cap table because so many investors pass on an single investment. So you could build a relationship with ten underrepresented investors and only have one say yes. (I generally set the expectation for founders that they’ll approach 100 investors in a round and 90 of them will pass.)
- Option 2: Founders can add diversity to their cap table using a crowd equity platform like Republic to offer a wider variety of stakeholders access to an ownership stake in the company. But those platforms are new and somewhat untested. Fringe even. While they hold huge potential to be a new layer in the capital stack, there are few experts and even less good advice in this arena.
- I prefer Option 3: Make it easier for diverse investors to say yes.
I propose the Rule of Five to help get more diverse investors on your cap table without changing anything about the process or overall terms of the round. The Rule of Five is a commitment to decreasing the investment minimum requirement in your round to 1/5th for five accredited diverse investors who you want to work with.
For example, if you’re raising a seed round and your investment minimum is $25K, for five diverse investors that you are excited to work with, choose a lower minimum check size, in this case, $5K. Or say your investment minimum is $50K in your round, then drop it to $10K for investors that bring a different perspective to your investor pool that would want on your cap table. Other than the lower investment minimum, they are on all the same terms as any other minority investors, meaning the paperwork is the same, so the only additional legal or overhead costs is whatever it takes to get their signatures and make sure their funds get wired.
It’s a pretty low bar for founders to add a few extra investors to a round. Well-organized rounds communicate signing and funding expectations leading up to the round closing, and a few extra people is a very marginal difference to the process. Founders have a lot of influence over the kind of round they want to raise, but first-time founders aren’t always aware of what they can decide and what’s not negotiable if they want to raise a “standard” round.
Founders should also commit to keeping their standards high for ALL investors on their cap tables. The Rule of Five is not an excuse to take on investors that you are not excited to have on your cap table. I’m also talking here about diverse accredited investors, which is a legally important status for your round. Check with your lawyer if you want to take money from an unaccredited diverse investor. There are GREAT diverse investors out there, it’s your work to find them and get them excited about what you are doing.
I have confidence this will work because for years I’ve seen startups offer a lower investment minimum for mentors they worked with at an accelerator. I’ve seen the power of getting great advisors on the cap table at a lower minimum. One founder said it best reflecting back a year after their raise,
“No one tells you that the size of the check an investor writes doesn’t perfectly correlate with how much time and energy they spend with you after the raise.”
Sometimes, the person who feels lucky to be invited in will do more for you than the one that writes the biggest check. The great news for founders is the Rule of Five is a policy you can implement today. It works for early fundraising rounds with very little overhead. If you decide to try it, talk about it. Make it part of your larger DE&I strategy because it has an impact not only on how your investors see your company, but also your employees and your community. This is one simple action step that can help all founders deliver on more cap table diversity.
I’ll be writing about the Rule of Five in a four-part series. Part two will describe some of the tools and the nuances of the Rule of Five like how do you find those diverse investors and how to approach diverse investors while avoiding any feelings of tokenism. Part 3 will be a case study on a startup who has successful implemented the Rule of Five in its seed round and Part Four will discuss how other stakeholders in the startup community like funds, accelerators and lawyers can support founders in using the Rule of Five in their rounds.
Also published on Medium: https://medium.com/the-soul-of-startups/the-rule-of-five-how-founders-can-create-cap-table-diversity-8fd9cefa6816