Cap table 101: What Founders Should Know About a Cap Table
The startup cap table is one of the most fundamental documents that every entrepreneur must know and understand. The moment a couple of founders come together to form a company, figuring out the equity distribution is inevitable. After this stage, the concept of a cap table follows. Ranging from simple cap tables maintained on spreadsheets to complex ones on equity distribution software, founders must understand the nuances of cap tables to ensure that they are up-to-date with details of company equity at every stage of growth.
Cap Table 101
When a startup is formed, equity distribution is the easiest. Based on the mutually agreed terms between partners, profits are distributed in a couple of ways. This can be easily tracked on a simple excel sheet. But as the business grows and more stakeholders come on board with equity stakes, the real role of a cap table structure comes to life. To understand this better, let’s start at the basics.
What is a cap table?
An operating business undergoes several processes that alter its equity structure regularly. This includes events such as funding rounds, stock issuance, share cancellations, transfers, exercising options, etc. A capitalization table otherwise known as the cap table is a live, up-to-date document containing all details of who owns how much in a company at all times, despite these shifts. Thus every founder must know how to build a cap table.
Equity is issued in many ways such as stocks, convertible notes, warrants, and equity grants, etc. A cap table structure is created in a way that can accommodate information about all types of equity grants from the very beginning stage of company operations. The basic details included in a cap table are names of stockholders, number of issued shares, date of issuance, date of vesting, expiration, etc. Apart from stockholder details, a cap table also includes information about total stocks already exercised and the option pool.
Thus a cap table is a comprehensive document that gives a candid picture of the company’s ownership stakes, equity dilution and changing values of equity after every funding round. Cap table 101 not only includes knowing who owns how much of the company but the additional process of regularly updating the document and sharing with all stakeholders as well.
A cap table structure not only shows who owns how much of the company but also demands a rigorous process of updating, monitoring, and regular communications with all stakeholders.
What does a cap table look like?
As discussed earlier, a cap table is a consolidated statement of a company’s equity. The basic requirement is to have the list of stakeholders on the Y-axis and details of all the securities on the X-axis. However, the actual cap table structure varies with company needs. In some cases, stakeholder details are listed elaborately while in some other structures they might simply be grouped under ‘founders’, ‘investors’, ‘employees’, etc. Similarly, details of securities could be elaborate or bunched together as ‘preferred shares’, ‘convertible notes’, and more.
There is no one way to represent a cap table. Based on the size of the company, stage of growth, and ownership structure, a founder is required to adopt the preferred approach suited to a particular business to build a cap table. Here are some of the basic parameters that must be included in a cap table:
- Name of all shareholders
- Number of shares owned by each shareholder
- Percentage of ownership held in the company
- Total number of outstanding shares
- Total number of stock options available for new issuance
- Option pool
|New Fund Raising||$2,500,000|
|Name||Common||Seed Series||Series A||Options||Option Plan||Outstanding Own.||Fully Diluted|
|Stock Option Plan||-||-||-||-||500,000||0.00%||5.92%|
Normally, a pattern is followed while listing stakeholders in a cap table structure. First, the founders, followed by the executives, then the employees holding stocks, and later the external stakeholders such as the angels and venture capitalists. Beyond these parameters, cap tables provide the flexibility to be adapted to suit various business requirements and the manpower available to track and manage them periodically.
Why do founders require a cap table for their company?
Cap table management is fundamental to every business. Maintaining a detailed document of stakeholder information is not a mere procedural necessity. Diligent analysis of a company’s cap table reveals critical information that determines the future course of action for a business. Here are some of the important scenarios that depend on the information derived from the cap table:
- Company stocks and voting rights: Based on the type of share ownership, stakeholders are entitled to voting rights. This privilege has powerful implications for management decisions. A quick look at the cap table structure enables founders to decide which shareholders must be involved as signatories in important company decisions.
- Company valuation and investors: Company valuations largely depends on information such as authorized shares (total shares a company can issue), outstanding shares (total shares already issued and held by shareholders), unissued shares (total number of shares not issued), option pool (total number of shares allocated for employee equity schemes), etc. detailed in a cap table. A valuation (see also 409a valuations) in turn is the foundation for funding rounds. Thus an efficient cap table management is important for founders to attract the right investors.
- Option pool and hiring: An option pool is a compulsory inclusion. Even a startup cap table must make provisions for an option pool. Founders refer to this section of the cap table to estimate how much equity is available to offer to new hires. It is an important component of salary packages especially in the early stages of a company. Even as the business grows and employees exit and new people come on board, the options pool helps keep track of how much equity is available for recruiting new talent.
- Outstanding shares and dilution: A cap table structure provides a snapshot of all outstanding shares held by stakeholders. Founders need this information to decide on the extent of dilution a business can afford in any circumstances. Thus an updated cap table is a quick reference guide for companies to take a stock of how much equity can be spared. We discuss more dilution in the following sections.
Cap table in different stages of a Startup
Founders typically spend a lot of time learning the ropes of startup management before launching one. But no matter how prepared they are, real learning happens only in practice. Managing cap tables is one such chapter in the startup story. It is one thing to know the need and functionalities of a cap table but a whole different game implementing the right approach at various stages of a startup. Here is a basic guide to startup cap table management at different phases of a new business:
- Phase I – The Idea: Origins of every startup is a brilliant, scalable idea. If a founder is working closely with just one other partner, then drawing a formal cap table is not required at this stage. However, if there are multiple co-founders contributing monetary as well as non-monetary resources (considered for sweat equity), they must discuss and clarify their shareholdings in the business. Once a consensus is reached about a share split and their respective vesting schedules, it is best to draw up a simple agreement acknowledging these decisions.
- Phase II – Startup incorporation: Once a startup is officially incorporated, cap table management is inevitable. It is best to take legal guidance in this process as the nature of tabulated data on a cap table may vary with industry and market needs. Here is the information included in a basic startup cap table:
- Date of startup incorporation
- Total number of authorized shares
- Stocks issued to founders (individual date of issue and vesting schedules)
- Founders’ details who have opted for 83b elections with IRS
- Size of option pool (advisable to budget equity payouts for at least the next 18 months)
- Phase III – Equity-based employee recruitment: Startups are generally low on cash flow. Thus most early-stage employee recruitment is done by offering lucrative equity packages in addition to below-market cash compensations. With the expansion of the startup culture in the last decade, employee equity has proven to be a great tool to hire, retain, and motivate employees in a startup. Employee’s financial interests automatically align with those of the company leading to better performance. By this phase, tracking and updating a startup cap table becomes a regular activity. ESOP grants are based on restricted stocks before a startup can afford a 409a valuation. Once this valuation is done and share value determined, a startup can grant stock options. The ESOP structure eventually becomes complicated with multiple classes of shares and their vesting schedules. Ensuring every employee is granted what they deserve and receive their equity incentives on time are fundamental to a startup cap table and this builds trust and transparency in the company.
- Phase IV – Angel/VC Investments: Startup funding happens in four stages – Seed, Series-A, Series-B, and Series-C. Seed funding supported by Angel investors generally begins around 250K. Then on, venture capitalists lead the finance rounds. By the time a startup hits Series B funding, it becomes a multi-million dollar company ready for global expansion. Then on, Series C becomes a need-based funding round for specific expansion/acquisition projects. Irrespective of the funding stage, all investors have these basic concerns:
- Stability in the startup’s ownership structure
- Liquidity after a fresh finance round
- Effect on the options pool post-money (extent of investor’s liability)
- Conversion features of convertible notes, warrants, SAFE
All this information is gathered only from a well-maintained and up-to-date startup cap table. Stronger the foundation of a cap table, the better the chances of a startup to bag the best investment deal. Seasoned investors do not place their faith in startups with shaky cap table management.
Key Terms Founders Should Know to Understand a Cap Table
Though cap table management varies with the type, size, and stage of business, there are certain basic terms founders must understand that are universal across all formats. These terms and concepts help the management navigate the workings of a cap table.
Pre-money valuation and Post money valuation
These two terms are used in the context of investment rounds. Pre-money valuation is the value of a company before new funds are added. Beyond company valuation methods, investors and company management engage in negotiations to arrive at an optimum pre-money valuation of a company before investments are finalized. Post-money valuation as the name suggests is the actual valuation of a company after the new funds are added. This value is always on the higher side.
When a company is created, common stocks are the standard stocks issued. Each common stock represents a unit of ownership in the company. Common stocks are owned by founders and employees and entitle the shareholder voting rights in important management decisions. Sometimes they might be entitled to dividends as well. However, on a payday or liquidation scenario, common stockholders are the last on the payment priority list.
These are a special category of stocks. From an investor’s point of view, these are low-risk investments. When a company is liquidated, preferred stockholders are the first ones to receive payouts and profit distributions. However not all preferred stockholders are entitled to voting rights as in the case of common stockholders.
Convertible notes are commonly used by startups to raise funds in the early stages. They are essentially loans that can be exchanged for equity after the company attains a certain milestone. Convertible notes are useful because investors need not arrive at a company valuation before investing in these. This is very useful in a startup set up as it is difficult to estimate the valuation of a business in the early stages. Convertible notes are commonly used by seed and angel investors.
Stock options are a part of the employee stock option plan. These are not stocks themselves, rather a contractual benefit granted to employees to purchase a set number of shares at a predetermined price on a particular date.
Stock options are a part of the employee stock option plan. At the time of grant, they are not actual stocks but a contractual benefit offered to employees by which they can buy stocks at a special price in the future. This special price is otherwise known as the ‘strike price’ and offered only to employees. It is valid till a particular date in the future. In case an employee does not exercise his options by this date, his benefits will lapse. Stock option grants are subject to vesting schedules and are a great employee motivation and retention tool. Stock options are of two types:
- Incentive Stock Options (ISO): These are granted only to employees. Stock value cannot exceed more than $100,000 a year. No tax is incurred at the time of grant or exercise. These grants are taxed as per the regular capital gains rate. However, employees can realize long-term gains only if they hold on to the stock for at least one year from the exercise date.
- Non-Qualified Stock Options (NSO): These can be granted to anyone beyond employees such as company partners, vendors, etc. on approval by board members. There is no limit on the value of NSO stock grants. Income from these grants is considered as normal income and taxed as per regular income tax rules.
Warrants function similarly to stock options. It entitles the holder the right to purchase a particular amount of stock at a pre-set price on a particular date soon. However, stock options are directed towards employees and other company beneficiaries while warrants are used in the context of business transactions.
Restricted stocks are also known as ‘letter stocks’ or ‘section 1244 stocks’ and are particularly used for executive compensation. These are non-transferrable stocks and are subject to restrictions on immediate sale. Normally restricted stocks are subject to graded vesting schedules that last for several years. These restrictions are put in place so that top executives stay invested in the company for the long term. Restricted stocks are of two types:
- Restricted stock units (RSU): This is a contractual benefit offered to employees to purchase a set number of shares at a predetermined price on a future date or achievement of certain milestones. RSU must be exercised to own stocks. Only then the voting rights are granted. RSUs can sometimes be redeemed for cash.
- Restricted stock award (RSA): These are actual stocks and employees become stock owners from the day of grant. RSA cannot be redeemed for cash.
Authorized shares otherwise known as authorized capital stock are the total number of shares a public company is permitted to issue. This limit is usually set in the company’s articles of incorporation. It is also listed under the capital accounts section of the balance sheet.
Fully diluted shares
Fully diluted shares are the count of total outstanding shares as well as those that may be converted shortly. Thus it includes not only the issued common shares but also convertible notes and employee stock options that hold a possibility of conversion soon.
Outstanding shares are the total number of shares held by all shareholders. It also includes the share blocks held by institutional shareholders as well as restricted stocks held by executives. However outstanding shares do not include stocks that are yet to be exercised. Total outstanding shares at any given point are not a static value and prone to fluctuations with time.
Dilution occurs every time a company issues a new set of shares beyond the ones already in the market. From a cap table structure, founders can determine the percentage of shares already traded and held by various stakeholders including employees and investors. This indicates the extent of dilution in the business and helps strategize further possibilities of dilution and its impact on existing shareholders.
Cap Table Structure
The cap table structure plays an important role in major business decisions. Thus founders must have clarity about the right format and the details to be included to ensure that the cap table serves its purpose of enabling well-informed decisions. In this section, we discuss how cap tables can be created and maintained:
Simple cap table example
Before exploring the elaborate process of creating a cap table structure, here is a simple example of how a cap table looks like. This format has all the basic details covered without going very deep into their bifurcations. For a startup, this is a good place to start:
|Name||Common Stock||Stock Options||Series A Preferred||Total Shares||Percent Outstanding||Percent Fully Diluted|
|Remaining Option Pool||-||280,000||-||280,000||-||7.0%|
Creating Cap Table
To maintain an updated cap table while keeping all stakeholders informed is a full-time job. It can be done manually in the initial stages but as the business expands and new stakeholders come on board and some old ones exit, keeping track of all vesting schedules and attending to every stakeholder’s need becomes an elaborate process prone to manual errors. Let’s take a look at the two basic methods of cap table management:
Using Excel sheets
Cap table structure on an excel sheet is the most basic format. It is as simple as a couple of entries about who owns how much in the company. This is a typical approach by startups. In the startup stage, maintaining cap tables on excel sheets is practical as companies at this stage operate with a handful of people. The volume of information to be handled in terms of equity is also low. Besides, an excel sheet provides the flexibility to customize a cap table as per the company’s needs.
But the situation changes with consecutive rounds of investments and recruitments based on employee equity. With every round of dilution, manually updating fluctuations in equity ownership becomes a complex task. After a point, equity management software becomes a sensible option. Before exploring that, here are the basic limitations with a cap table structure on an excel sheet:
- Cap tables on an excel sheet cannot be scaled with business growth. With numerous stakeholders including and updating new entries regularly on an excel sheet becomes prone to errors that have serious legal implications.
- In these stages of increasing complexity, law firms are involved in cap table management. This is an expensive affair as well as cumbersome to consolidate all versions of the cap table to suit IRS and SEC regulations.
Using cap table software
Cap table software comes with a much more flexible and user-friendly approach than excel sheets. These are designed by companies specializing in equity management and are a consolidation of best practices across all stages of business and diverse industries. Though the features are suitable for a complex business process, it is advisable to use cap table software right from the company’s inception so that all equity management efforts are streamlined from the start. Besides, the best of investors these days prefer working with companies operating with cap table software.
Why Founder’s Prefer Softwares to Create and Manage Cap Tables?
Based on the limitations of cap table management on excel sheets, here are the biggest advantages provided by equity management software:
- Cost saver: Beyond the initial investment of purchasing the software license, cap table software reduces the overall cost of equity management reducing costs on finance professionals, manual/paperwork communications with stakeholders, and possibly legal penalties in case of manual errors.
- Automated process: The entire process is automated with cap table software. Manual updating and tracking on every step after the company valuation, new stock issuance, or liquidity are no longer necessary. The software is equipped to update the relevant records and inform the relevant stakeholders based on their equity ownership.
- Single point of reference: Cap table software is a single point of reference. Unlike cap tables on excel sheets which can have multiple versions depending on who is handling it, cap table software is standardized. Besides, every stakeholder can be granted personalized access to their equity accounts. Updated information is available at all times. This kind of customized access is not possible with a spreadsheet.
What else can you do with cap table software?
Though the basic function of a cap table is to facilitate an easy understanding of equity transactions, there are many other aspects to it beyond the knowledge of who owns how much. In current market scenarios, it is not enough for cap table software to just manage cap tables. The requirements stretch wide to include all aspects of a wholesome equity management process. Here are some of the extended services provided by sophisticated equity management software such as Eqvista:
- Issuing stocks and shares: Cap tables help track issued shares, but cap table software such as Eqvista helps issue shares as well. Once the necessary approvals are in place, the Eqvista platform enables a smooth online share issuance process in a couple of clicks. Besides, digital share certificates can be easily generated and distributed to the appropriate shareholders. Here is a detailed process flow for digital share issuance with Eqvista.
- Waterfall analysis: Eqvista has one of the most powerful financial modeling systems, especially for a waterfall analysis. Besides managing cap tables, integration of waterfall financial modeling enables users to truly visualize the data from cap tables in the context of an exit scenario. Here is how this works on Eqvista.
- Real-time sharing: Eqvista enables customized access to all stakeholders. This helps in two things – first, all stakeholders can view their equity information in real-time, and second, based on access levels, management can share all relevant information with stakeholders in one go. One can imagine that the level of access for founders is not the same for employees or third-party investors. Thus real-time sharing is an important tool for easing the process of equity management, which is a complex aspect one cannot imagine with even password-protected spreadsheets.
Manage Your Company Cap Table on Eqvista
Working with high-end equity management software such as Eqvista from the time a company is formed is a good choice for new entrepreneurs. One can save time and money trying to consolidate spreadsheet cap tables. To understand the full range of services, from cap table management to 409a valuations provided by Eqvista, read these articles. To know more, reach us today.