Cap table due diligence for UK startups: avoid common legal, tax and dilution mistakes

Legal Record vs. Spreadsheet: A Common Source of Cap Table Mistakes for UK Startups

For UK founders approaching a funding round, the arrival of an investor's due diligence questionnaire shifts the focus internally. Suddenly, the capitalization table, a document often left untouched for months, becomes the centre of attention. This is more than just a spreadsheet; it is the legal and financial ledger of your company's ownership. Getting it wrong introduces friction, delays, and doubt at the worst possible time. The most common cap table mistakes for UK startups fall into three areas: misalignment with official legal records, non-compliance with UK tax-advantaged schemes, and inaccurate modelling of future dilution. Addressing these proactively transforms due diligence from a painful ordeal into a smooth, confidence-building process.

Does Your Cap Table Match Companies House Filings?

The first question an investor's legal team will ask is whether your internal cap table matches the legal reality. In the UK, the definitive source of truth for share ownership is not your meticulously crafted spreadsheet; it is the public register at Companies House. Any discrepancy between the two is an immediate investor red flag, suggesting a lack of administrative rigour and creating share ownership problems from the outset.

This gap typically emerges from simple operational pressures. When a startup is focused on product development and finding customers, administrative filings can be forgotten. The key filing in this context is the form SH01, or "Return of allotment of shares", which is used to notify Companies House of new share issuances. This is not optional. UK law is clear: "UK companies have a statutory deadline to file an SH01 form within one month of allotting shares." (Companies Act 2006).

A scenario we repeatedly see is a founder receiving a term sheet, only to realise that share issuances from an early angel round 18 months ago were never formally filed. This triggers a frantic and expensive rush, requiring lawyers to piece together board minutes, signed resolutions, and bank records to file the historical SH01s correctly. The practical consequence tends to be a delay in the funding round and an erosion of investor confidence. Keeping your internal records and Companies House filings perfectly synchronised is fundamental to good equity management.

Navigating UK Tax Schemes: SEIS, EIS, and EMI Compliance

UK startups have access to some of the world's most generous tax-advantaged schemes for investors and employees. These include the Seed Enterprise Investment Scheme (SEIS), the Enterprise Investment Scheme (EIS), and the Enterprise Management Incentive (EMI) option scheme. While these are powerful tools, they come with strict compliance overhead that is closely scrutinised during due diligence.

Are Your Investor and Employee Schemes Compliant?

For investors, the tax relief offered by SEIS and EIS is a primary motivator. To unlock this benefit, your work does not end when you receive their investment. "S/EIS3 compliance certificates are required for investors to claim tax relief under the SEIS/EIS schemes." If you fail to apply for and distribute these certificates correctly, your investors cannot claim their tax relief, which can seriously damage the relationship and your reputation.

For employees, the EMI scheme is the gold standard for equity compensation, but its favourable tax treatment is conditional on timely notification to HMRC. The rule is absolute: "For the Enterprise Management Incentive (EMI) scheme, companies must notify HMRC of an option grant within 92 days of the grant date." Missing this deadline has severe tax issues for founders and their teams. "Failure to meet the EMI 92-day notification deadline can disqualify the options from favourable tax treatment, potentially subjecting the employee to income tax instead of Capital Gains Tax on their gains." Our guide on UK employment contracts and option documentation provides more detail.

Case Study: The Missed 92-Day EMI Deadline

Consider a pre-revenue Deeptech startup that grants EMI options to its first key technical hire. The founder, consumed with R&D milestones, makes a note to handle the HMRC paperwork but misses the 92-day notification window. Eighteen months later, during a Series A due diligence process, the investor's lawyers review all employee option agreements and cross-reference them with HMRC filings. They quickly flag that the initial grant was never registered. The consequence is significant. The options are disqualified, meaning the employee faces a massive, unexpected tax bill upon a future exit. Their profit will be subject to Income Tax and National Insurance instead of the much lower Capital Gains Tax rate, damaging morale and trust.

Modelling the Future: Avoiding Startup Equity Mistakes from Convertible Instruments

Perhaps the most common shock for founders during a funding round comes from dilution. Specifically, it is the misunderstanding of how early-stage funding instruments like SAFEs (Simple Agreements for Future Equity) and Convertible Loan Notes (CLNs) will impact their ownership when a priced equity round occurs. Many founders track ownership on a simple spreadsheet that only shows the current state, failing to build a 'pro-forma' cap table that models the future.

Have You Accounted for the ‘Double Dilution’ Effect?

This lack of forward modelling leads directly to one of the most painful moments for founders: discovering their post-fundraise ownership stake is far smaller than they anticipated. Most pre-seed startups accept convertible instruments to close funding quickly, but defer the complex modelling. This complexity often involves a 'Double Dilution' effect. The first dilution occurs when the notes convert into equity, typically at a discount or based on a valuation cap. The second dilution happens immediately after, when the new lead investor requires the creation of a new employee option pool as a condition of their investment. This new pool is almost always calculated on the pre-money valuation, diluting all existing shareholders, including the founders, before the new investment cash comes in.

Understanding the distinction between pre-money and post-money convertible instruments is also vital. While post-money SAFEs are common in the US, UK deals still frequently use pre-money instruments. These can provide founders with more clarity on their dilution from the convertible itself, though they still face the option pool dilution.

Example: How SAFE Conversion Dilutes Founder Equity

To make this tangible, let’s illustrate the dilution from a convertible note converting during a new funding round. Imagine a company with 1,000,000 founder shares. They previously raised £200,000 on a SAFE with a £2,000,000 valuation cap. Now, they are raising a £1,000,000 Series A at a £4,000,000 pre-money valuation.

1. Starting Position: Initially, the founders own 1,000,000 shares, representing 100% of the company.
2. SAFE Conversion: The £2,000,000 valuation cap is lower than the £4,000,000 Series A valuation, so the cap is used for conversion. The £200,000 from the SAFE converts into 100,000 new shares (£200,000 investment ÷ £2,000,000 cap gives the SAFE holders a 10% stake on a pre-conversion basis). The company now has 1,100,000 shares outstanding, with founders holding 90.9% and SAFE investors holding 9.1%.
3. New Investment: The new investor purchases £1,000,000 of equity. At a £4,000,000 pre-money valuation, this buys them 275,000 new shares. The total number of shares increases to 1,375,000.
4. Final Ownership: After the round closes, the founders’ 1,000,000 shares represent 72.7% of the company. The SAFE holders now own 7.3%, and the new Series A investor holds 20%. This example does not even include the 'double dilution' from creating a new 10-15% option pool, which would reduce these percentages further.

Three Disciplines for Proactive Cap Table Management

A well-maintained cap table is a sign of an organised, professional operation and is crucial when preparing for due diligence. It prevents unforced errors that can delay funding and damage trust with investors. Founders who successfully navigate this process typically focus on three disciplined habits.

1. Reconcile Your Legal Record Immediately. After every single share allotment, reconcile your cap table with Companies House by filing the SH01 form. Do not wait. Set a recurring calendar reminder or use a cap table management platform to automate this process.
2. Create Compliance Checklists. For UK-specific schemes, create a simple checklist for every SEIS/EIS investment and every EMI option grant. The 92-day HMRC notification rule for EMI must be treated as a non-negotiable deadline.
3. Model Your Future Dilution. Move beyond a simple ownership list. Use a tool or a properly structured spreadsheet to build a pro-forma model that shows how convertible notes and new option pools will dilute your stake in the next round.

This proactive management avoids costly, last-minute clean-ups and demonstrates to investors that you have a firm grasp on the financial and legal structure of your business.