Cap Table Adjustments for Startups from Seed stage to Exit
In this article, we will review the various adjustments that your cap table goes through from the seed to the IPO stage.
A startup’s ownership structure changes gradually as it onboards new investors, rewards employees with stock options, and finally goes public. These changes can significantly affect your control over your startup and impact investor returns. A good example of prudent equity management would be Eric Yuan, the founder and CEO of Zoom. By the time of Zoom’s IPO, he had successfully retained a 22% ownership stake in the company.
To emulate Mr. Yuan’s success in equity management, you must be informed about what to expect. Hence, in this article, we will review the various adjustments that your cap table goes through from the seed to the IPO stage.
Founding Stage – The Initial Cap Table
At the inception, most startups will divide ownership equally among all founders. So, if a startup has 4 founders, each founder would own 25% of the startup. Suppose your startup’s initial valuation was $500,000, and there were 4 founders. Then, the value of each founder’s stake would be $125,000 (25%×$500,000).
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 200,000 | 25% | $125,000 |
| Founder #2 | Common stock | 200,000 | 25% | $125,000 |
| Founder #3 | Common stock | 200,000 | 25% | $125,000 |
| Founder #4 | Common stock | 200,000 | 25% | $125,000 |
| Total | 800,000 | 100% | $500,000 |
Prior to your first external investment, the cap table is extremely straightforward, as you haven’t issued complex securities or created any option pools.
Welcoming Angel Investors – The First Dilution Event
Typically, you would experience dilution for the first time at the seed funding round. Since you would be issuing convertible securities instead of common stock, the dilution impact materializes at a later date, upon conversion.
At this stage, since ascertaining a startup’s valuation is challenging, most startups issue Simple Agreements for Future Equity (SAFE) notes. This is a type of convertible security that can be converted into common stock on the basis of a valuation cap or a conversion price. To reward the early investors for supporting the startup at a high-risk stage, the valuation cap and the conversion price are usually at a discount.
So, if your supposed valuation at the seed stage was $5 million, the valuation cap might be set at $4 million or even $2 million. Similarly, if the stock price of common stock was $4, the conversion price might be set at $2 or $1.5.
In our example, the SAFE notes have a conversion price of $1.6 while the stock price of a common stock is $1.875.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 200,000 | 25% | $375,000 |
| Founder #2 | Common stock | 200,000 | 25% | $375,000 |
| Founder #3 | Common stock | 200,000 | 25% | $375,000 |
| Founder #4 | Common stock | 200,000 | 25% | $375,000 |
| Angel investor #1 | SAFE notes (Conversion price of $1.6) | N.A. | N.A. | $500,000 |
| Angel investor #2 | SAFE notes (Conversion price of $1.6) | N.A. | N.A. | $500,000 |
| Total | 800,000 | 100% | $2,500,000 |
We can see that the entry of angel investors does not immediately change the ownership percentages of each founder. Suppose a year later, your angel investors convert their SAFE notes. Then, your cap table would take the following form.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 200,000 | 14.04% | $701,754 |
| Founder #2 | Common stock | 200,000 | 14.04% | $701,754 |
| Founder #3 | Common stock | 200,000 | 14.04% | $701,754 |
| Founder #4 | Common stock | 200,000 | 14.04% | $701,754 |
| Angel investor #1 | Common stock | 312,500 | 21.93% | $1,096,491 |
| Angel investor #2 | Common stock | 312,500 | 21.93% | $1,096,491 |
| Total | 1,425,000 | 100.00% | $5,000,000 |
In this example, the ownership percentage for every founder dropped from 25% to 14.04%. Ideally, this post-conversion dilution impact should be considered before issuing convertible securities such as SAFE notes.
Series A Financing – The Entry of Institutional Investors
Unless a startup has an extremely attractive business model or technology, Series A rounds are the earliest entry point for institutional investors such as venture capital firms. However, an exception to this could be VCs that specifically focus on investing seed-stage startups or are extremely stage agnostic.
The Series A funding round is also the first possible exit opportunity for angel investors. They could exit the startup by selling their shares to the founders or the incoming investors, or through buybacks by the startup. A buyback would negate the original dilution impact as the shares are retired. However, since this depletes a startup’s cash reserves, most early-stage startups would not want to facilitate exits in this manner.
In our example, we will first see the impact of angel investors selling their stake to incoming VC firms and founders. Then, we will explore the dilution impact of Series A round investments.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 278,125 | 19.52% | $1,951,754 |
| Founder #2 | Common stock | 278,125 | 19.52% | $1,951,754 |
| Founder #3 | Common stock | 278,125 | 19.52% | $1,951,754 |
| Founder #4 | Common stock | 278,125 | 19.52% | $1,951,754 |
| VC firm #1 | Common stock | 156,250 | 10.96% | $1,096,491 |
| VC firm #2 | Common stock | 156,250 | 10.96% | $1,096,491 |
| Total | 1,425,000 | 100.00% | $10,000,000 |
By providing exits to angel investors, the founders can protect their ownership percentage. If the VC firms were allowed to facilitate exits by themselves, it would result in severe dilution at the Series A stage.
Now, let us observe the cap table impact of $4 million in VC investments.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 278,125 | 13.94% | $1,951,754 |
| Founder #2 | Common stock | 278,125 | 13.94% | $1,951,754 |
| Founder #3 | Common stock | 278,125 | 13.94% | $1,951,754 |
| Founder #4 | Common stock | 278,125 | 13.94% | $1,951,754 |
| VC firm #1 | Common stock | 441,250 | 22.12% | $3,096,491 |
| VC firm #2 | Common stock | 441,250 | 22.12% | $3,096,491 |
| Total | 1,995,000 | 100.00% | $14,000,000 |
We can observe that each founder’s ownership percentage dropped from 19.52% to 13.94%. However, compared to the ownership percentages at the seed stage, the drop is marginal. This is because the founders were able to partially facilitate angel investor exits.
Impact of Equity Incentives
Stock-based compensation is often used by startups to attract top talent while conserving cash reserves. Founders can also utilize stock-based compensation to protect themselves against dilution. Unless the stock-based compensation is excessive, most investors may agree to this practice as it keeps the founders as well as the employees motivated.
In our example, we will first see the cap table impact of the creation of two stock option pools, one for employees and one for founders. Then, we will see how the conversion of stock options impacts your cap table.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 278,125 | 13.94% | $1,951,754 |
| Founder #2 | Common stock | 278,125 | 13.94% | $1,951,754 |
| Founder #3 | Common stock | 278,125 | 13.94% | $1,951,754 |
| Founder #4 | Common stock | 278,125 | 13.94% | $1,951,754 |
| VC firm #1 | Common stock | 441,250 | 22.12% | $3,096,491 |
| VC firm #2 | Common stock | 441,250 | 22.12% | $3,096,491 |
| Employee stock option pool | Stock options | 200,000 | N.A. | $1,403,509 |
| Founder stock option pool | Stock options | 100,000 | N.A. | $701,754 |
| Total | 1,995,000 | 100.00% | $16,105,263 |
Suppose that over 3 years, the stock options vest and are exercised. In this period, the size of the option pools and your startup’s valuation are all doubled. Let us explore the cap table impact of such events.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 303,125 | 13.21% | $3,372,648 |
| Founder #2 | Common stock | 303,125 | 13.21% | $3,372,648 |
| Founder #3 | Common stock | 303,125 | 13.21% | $3,372,648 |
| Founder #4 | Common stock | 303,125 | 13.21% | $3,372,648 |
| VC firm #1 | Common stock | 441,250 | 19.23% | $4,909,463 |
| VC firm #2 | Common stock | 441,250 | 19.23% | $4,909,463 |
| Employee shareholders | Common stock | 200,000 | 8.71% | $2,225,252 |
| Employee stock option pool | Stock options | 400,000 | N.A. | $4,450,504 |
| Founder stock option pool | Stock options | 200,000 | N.A. | $2,225,252 |
| Total | 2,295,000 | 100.00% | $32,210,526 |
We can observe that the founders only experienced a marginal amount of dilution since they received stock options. In contrast, the collective ownership of venture capital firms went down from 44.24% to 38.45%.
Series B Financing – Scaling Up and Further Dilution
From Series B onwards, startups seek significant capital infusions to scale operations rapidly, expand geographically, and diversify their product offerings. Due to the large size of these funding rounds, they cause significant dilution.
We will now continue our example and see how a $30 million Series B funding round impacts your startup’s cap table.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 303,125 | 8.55% | $7,275,000 |
| Founder #2 | Common stock | 303,125 | 8.55% | $7,275,000 |
| Founder #3 | Common stock | 303,125 | 8.55% | $7,275,000 |
| Founder #4 | Common stock | 303,125 | 8.55% | $7,275,000 |
| VC firm #1 | Common stock | 441,250 | 12.45% | $10,590,000 |
| VC firm #2 | Common stock | 441,250 | 12.45% | $10,590,000 |
| Employee shareholders | Common stock | 200,000 | 5.64% | $4,800,000 |
| Series B investor #1 | Common stock | 625,000 | 17.63% | $15,000,000 |
| Series B investor #2 | Common stock | 625,000 | 17.63% | $15,000,000 |
| Employee stock option pool | Stock options | 400,000 | N.A. | $9,600,000 |
| Founder stock option pool | Stock options | 200,000 | N.A. | $4,800,000 |
| Total | 3,545,000 | 100.00% | $99,480,000 |
We can observe that the founders experience significant dilution. Each founder’s ownership percentage drops from 13.21% to 8.55%. The existing investors and employee shareholders also experience similar levels of dilution. However, you must also note that the share price has more than doubled. Hence, this dilution did not significantly erode the value of pre-existing shareholders’ stakes, and they still saw meaningful gains.
Going Public – Cap Table Transformation at IPO
The initial public offering (IPO) is a significant event in a startup’s journey. Not only does it serve as a major opportunity to raise capital, but it also boosts the startup’s visibility and enhances its credibility. Furthermore, the increased access to capital markets helps facilitate future growth.
Let us continue our example and explore the impact of an IPO on your startup’s cap table. We will assume that you raised $1 billion through a fresh issue and the incoming institutional investors provided exits to all employee shareholders and pre-existing investors.
| Stakeholders | Descriptions | Units | Ownership percentage | Value |
|---|---|---|---|---|
| Founder #1 | Common stock | 303,125 | 1.29% | $15,156,250 |
| Founder #2 | Common stock | 303,125 | 1.29% | $15,156,250 |
| Founder #3 | Common stock | 303,125 | 1.29% | $15,156,250 |
| Founder #4 | Common stock | 303,125 | 1.29% | $15,156,250 |
| Incoming institutional investor #1 | Common stock | 4,583,125 | 19.47% | $229,156,250 |
| Incoming institutional investor #2 | Common stock | 4,583,125 | 19.47% | $229,156,250 |
| Incoming institutional investor #3 | Common stock | 4,583,125 | 19.47% | $229,156,250 |
| Incoming institutional investor #4 | Common stock | 4,583,125 | 19.47% | $229,156,250 |
| Retail investors | Common stock | 4,000,000 | 16.99% | $200,000,000 |
| Employee stock option pool | Stock options | 400,000 | N.A. | $20,000,000 |
| Founder stock option pool | Stock options | 200,000 | N.A. | $10,000,000 |
| Total | 23,545,000 | 100.00% | $1,207,250,000 |
Due to the massive IPO and the institutional investors facilitating exits to pre-existing investors and employee shareholders, the ownership of founders dwindled. Each founder’s ownership percentage has dropped from 8.55% to 1.29%. Once again, the dilution did not impact their returns due to the rise in the stock price.
At this stage, if the founders decide to exit, they would collectively be paid approximately $60 million, a significant increase from the initial valuation of $500,000.
Eqvista – Enabling You to Track Ownership Effortlessly!
As a startup founder, you must anticipate the impact of various funding events and complex securities. While these things can help you access much-needed capital, they also represent dilution risks. To help you make equity decisions, Eqvista’s software will enable you to visualize the impact of funding rounds and complex securities such as convertible notes and preferred shares.
Contact us today to get a demonstration!
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