Cap Table Due Diligence: Common Red Flags That Can Kill Your Fundraising

Cap Table Due Diligence: Why It Matters for US Startups

When a venture capital term sheet lands, the relief is quickly followed by a request for the due diligence checklist. At the top of that list is always the capitalization table. For US startups, particularly those navigating their pre-seed to Series B rounds, this is not a simple administrative check. The cap table is a test of truth, revealing the company's history of promises, financial discipline, and legal hygiene. Serious cap table issues before fundraising can delay a closing, force a valuation cut, or even kill a deal entirely. Investors are not just looking for a list of shareholders; they are scrutinizing the very foundation of your company's ownership structure. This article breaks down the three most common red flags investors find and provides a clear path to get your equity house in order before the diligence process begins.

What Investors Actually Look For in Your Cap Table

An investor’s lawyer is not just checking your math. The review is a core part of the wider investor due diligence process. During cap table diligence, they are verifying a single, critical concept: clear and defensible title to the equity. They need to confirm that every share, option, and warrant is accounted for, legally issued, and that no unrecorded claims could emerge later to dilute their investment or create legal challenges.

Diligence isn't just about matching numbers; it’s about risk mitigation. Your cap table tells a story of your company’s governance. Is it clean, organized, and backed by a complete set of documentation? Or is it a patchwork of handshake agreements, informal promises, and missing paperwork? Investors are buying a piece of that story, and they need assurance that the pages aren’t missing. These gaps represent significant startup equity structure risks that can be expensive to resolve.

The reality for most pre-seed to Series B startups is more pragmatic. Founders are often running finance themselves, making it easy for small oversights to compound into significant problems over time. Understanding this investor perspective is the first step toward a successful pre-fundraise equity cleanup.

Red Flag #1: Unrecorded Promises and Spreadsheet Errors

The most common starting point for cap table management is a spreadsheet. It seems simple enough for the first few founders, but it quickly becomes a liability. The primary problem is that spreadsheets lack a verifiable audit trail. They are vulnerable to formula errors, version control chaos, and accidental data entry mistakes that create serious cap table issues before fundraising.

When an investor’s counsel receives a spreadsheet, their first assumption is that it contains errors. They will spend expensive legal hours reconstructing it from legal documents, a process that immediately slows the deal and erodes confidence. This contrasts sharply with dedicated cap table platforms like Carta or Pulley, which serve as a single source of truth. These systems link every entry directly to its corresponding legal document, such as a stock purchase agreement or an option grant, creating an unchangeable and auditable history. The difference is between an informal ledger and a formal registry of ownership.

The Danger of Informal Equity Promises

A scenario we repeatedly see involves unrecorded promises. A SaaS startup founder, eager to hire a key engineer, includes a line in the offer letter promising “0.5% of the company.” The engineer accepts, the promise is filed away, but the grant is never formally documented by the board or entered into the cap table. Months later, during fundraising diligence, this offer letter surfaces. It creates immediate ambiguity. Was that 0.5% of the fully diluted shares at the time of the offer? Is it from the option pool? Does it vest? What is the strike price?

This single informal promise can halt a financing round while lawyers negotiate a resolution. The outcome is often a larger-than-intended grant to appease the employee, which dilutes all other shareholders, including the new investors. These are the option grant mistakes that transform a simple spreadsheet into a spreadsheet of doom, creating entirely avoidable legal costs and delays.

Red Flag #2: The Stale or Flawed 409A Valuation

Many founders believe that simply having a 409A valuation checks the box for compliance. However, the validity of that valuation is what truly matters to investors and the IRS. A 409A valuation is an independent appraisal of a company's common stock Fair Market Value (FMV). Its primary purpose is to set a legally defensible strike price for employee stock options. Issuing options below this FMV can trigger significant tax penalties for both the employee and the company, creating a liability that investors will demand be fixed before they invest.

Common 409A Valuation Pitfalls

Obtaining a valuation from a qualified, independent appraiser provides a “safe harbor,” meaning the IRS will presume the valuation is fair unless it is proven to be grossly unreasonable. This protection, however, is not permanent. A valuation’s validity is bound by two key rules. First is the "12-Month Rule", a standard stating that a valuation is generally considered valid for up to 12 months. After a year, it’s considered stale and a new one is required.

More critical are the rules around invalidation. A 409A is immediately invalidated by a "material event." What constitutes a material event? The threshold includes closing a new round of financing, receiving a term sheet, or a major operational milestone that significantly changes the company's valuation outlook. This is one of the most common 409A valuation pitfalls. For instance, consider a US-based Biotech startup that receives positive results from a preclinical study. This milestone dramatically improves its commercial prospects and, therefore, its valuation.

Even if its 409A valuation is only five months old, it is now obsolete. Continuing to issue option grants at the old, lower strike price is a serious compliance error. During due diligence, an investor’s lawyer will map the dates of option grants against the company’s timeline of material events. A mismatch is a major red flag that signals a lack of internal controls and potential tax liabilities that require an expensive pre-fundraise equity cleanup.

Red Flag #3: Missing or Incomplete Corporate Paperwork

Setting up a Delaware C-Corp is a standard first step for most US startups seeking venture capital, but incorporation is just the beginning. The ongoing corporate governance, especially around equity, is what investors scrutinize. One of the most damaging and surprisingly common investor red flags in cap tables is the disconnect between an equity promise and its formal, legal execution. Every single share issued and every option granted requires a clear and complete paper trail.

Delaware Incorporation Issues and Equity Grants

Under Delaware corporate law, equity issuances require a clear chain of written corporate approvals from the Board of Directors and, in some cases, stockholders. An informal email or a mention in an offer letter does not constitute a legal grant. The legal reality is different. The process must involve a formal, written consent from the Board of Directors that explicitly approves the specific grant. This document must include the recipient's name, the number of shares or options, the vesting schedule, and the strike price, which must be at or above the current 409A FMV.

Consider a Deeptech startup that hires a new head of research. The offer letter, dated March 1, promises 50,000 stock options. The founder and the new hire sign it, and everyone moves on. However, the Board of Directors does not hold its quarterly meeting and formally approve the grant via written consent until May 10. The legal grant date is May 10, not March 1. If the company secured a major government R&D grant in April, that material event would have required an updated 409A valuation.

The strike price for the May 10 grant must be based on the new, higher valuation. Diligence lawyers will meticulously cross-reference the date on the Board consent with the grant date in the option agreement and the cap table. Any discrepancy suggests poor governance and could potentially invalidate the grant, triggering a need for legal ratification of past actions. These Delaware incorporation issues are entirely avoidable with a disciplined process, but they are expensive and time-consuming to fix in the middle of a fundraise.

How to Prepare Your Cap Table for Fundraising

Addressing cap table issues before fundraising is not about legal perfection, but about demonstrating operational discipline and reducing friction for investors. By focusing on a few core habits, founders can build a diligence-ready company from the early stages, ensuring a smoother and faster path to closing their round.

1. Establish a Single Source of Truth. Get off spreadsheets for cap table management as soon as you issue your first SAFE, convertible note, or option grant. Transitioning to a dedicated cap table platform is the single most effective way to prevent the errors and gaps that plague manual trackers. These platforms serve as a central repository for all equity-related documents and enforce a structured workflow for new issuances, creating the clean audit trail investors expect.
2. Maintain Proactive 409A Compliance. Treat your 409A like a recurring compliance deadline, not a one-time task. Set a calendar reminder at the 10-month mark to begin the renewal process. More importantly, establish an internal trigger for a new valuation. Any time you receive a term sheet, hit a major product milestone, or achieve a breakthrough in R&D, the first call should be to your lawyer and valuation provider. This proactive approach avoids the risk of issuing mispriced options and demonstrates strong internal controls.
3. Standardize Your Equity Issuance Process. Implement a simple checklist for every new grant to ensure proper startup legal compliance USA. This workflow prevents the paperwork gaps that cause delays and legal fees down the line. It should include three steps:
   • The Board of Directors approves the grant via a formal, written consent.
   • The corresponding legal agreements (e.g., Stock Option Agreement) are generated and signed by both parties.
   • The grant is immediately recorded on your cap table platform, linking the new entry to the executed documents.

This simple workflow prevents gaps and ensures every grant is properly authorized and documented from day one. Clean records build investor confidence and signal that your company is built on a solid legal and financial foundation. For more information on preparing for a fundraise, visit the investor due diligence hub.

Frequently Asked Questions

Q: What is the first thing an investor's lawyer does with a cap table?
A: The lawyer typically starts by reconciling the cap table against the company's formation documents, board consents, and financing agreements. Their goal is to verify that every number on the table is supported by a legal document and that the fully diluted share count is accurate.

Q: Can I fix cap table mistakes during the due diligence process?
A: Yes, mistakes can be fixed during diligence, but it is often costly and time-consuming. The process can delay your closing and may require complex legal remedies, such as board ratifications or amendments to past agreements. Addressing these issues beforehand saves time, money, and founder credibility.

Q: What happens if an employee was granted options with the wrong strike price?
A: Issuing options below the 409A Fair Market Value can create significant tax penalties under IRS Section 409A for the employee. During diligence, investors will require the company to fix this. This may involve repricing the options (which requires board and sometimes shareholder approval) and addressing the tax liability.

Q: How can I identify unrecorded equity promises before fundraising?
A: A pre-fundraise equity cleanup should include a review of all employment offer letters, advisory agreements, and contractor agreements. Search these documents for any language promising "equity," "percent ownership," or "stock options" to ensure every promise has been properly documented and recorded on the cap table.