Understanding Startup Cap Table
This article would outline all you need to know about the startup cap table structure.
Starting a business comes with its many challenges, from developing a marketable product, managing your company products with suppliers and customers, to reducing the company expenses and maintaining enough cash. However, one important task for all successful startups is how to record their company shares and shareholders in an easy and effective way. This overview of the company’s shares is held in a startup cap table, or capitalization table, and is one of the most common and crucial lists that every entrepreneur needs to know to make smart decisions for their business.
Understanding Cap Table for Startup
A cap table is a spreadsheet for a startup company that lists all the company’s securities, its shareholders, and the price paid by investors to hold these securities. It displays every shareholder’s ownership percentage and how it can be diluted over time. Basically, a cap table is a standing summary of who owns what in your company. It is an important part of information for every early-stage investment.
Why is a Cap Table important for Startups?
Well, we wouldn’t be talking about a startup cap table if it wasn’t important. In fact, it is crucial for potential investors. When you are about to take up outside funding, the investors normally ask you to show them your company’s cap table. They want to see if you have raised money before and who owns how much of the company. Investors are mainly interested in this information and nothing else, aside from your ideas.
The reason why they want to know who else has invested is to see how much they would hold of the company and which of their competitors have invested in the company already. In addition to this, they also want to know how many shares would be given away and how will their ownership be diluted. So, a cap table has to be right and it is not a good thing if a founder screws up the startup cap table at the onset.
Key terms in a Cap Table
To understand the main idea of a startup cap table structure, you need to know all the terms involved. You should know all of its terms to speak fluently in the language when making deals with investors. To help you understand things better, each term has been separated into three categories namely valuations, security types, and share counts.
There are three terms that come under this. These include:
- Pre-Money Valuation – This is the valuation before any investment is made in the company. The valuation here is normally set through a negotiation between the company management and the investors.
- Post-Money Valuation – This is the effective valuation of the company after an investment has been made. For instance, if the pre-money valuation is $3M and the investors make an investment of $2M, the post-money valuation would be $5M.
- Price per Share – This is a calculation based on taking the post-money valuation and dividing it by the number of fully diluted shares. If we have a $10M post-money valuation and there are 5 million shares, the price per share is $2.
#2 Security Types
The next section of the startup cap table structure are the security types. These include:
- Common Stock – This is the most basic form of equity ownership in a company. Each share in this stock represents partial ownership of the company and gives the shareholder certain rights to company profits and voting on company matters, as listed in the law of the state of incorporation and in the charter.
- Preferred Stock – A series or class of stock with special privileges and rights outlined in the charter of the company. By default, preferred stock is normally paid for before common stock, but after the debt in a sale or liquidation situation.
- Convertible Preferred Stock – This is the preferred stock that has the option to convert into common stock, under a specified set of circumstances, including at the holder’s discretion.
- Participating Preferred – This is the kind of preferred stock that has the right to be paid some multiple of the original purchase price (example 1X or 2X), and then it also converts to common stock. After that, it simply participates in the distribution to common shares as if it had simply converted in the first place.
- Non-participating Preferred – This is the kind of preferred stock that has the right to be paid some multiple of the original purchase price as the participating preferred stock, or convert into common stock and participate in the distribution to common shares. In such a case, the investor chooses the liquidity method that offers the most financial return.
- Stock Options – A stock option is a contractual right to purchase a specified number of shares for a determined price at a future date. They are normally issued under the terms of a stock option plan out of a pre-approved pool of shares set aside for options and restricted stock grants. These are normally offered to employees.
- Warrants – Warrants are almost the same as options, where it offers the right to purchase a particular number of shares for a determined rate at a specific date. But unlike options, warrants are normally one-offs, and are not issued under the terms of a stock option plan even though the shares can be used from the left over option pool. Warrants are used mostly for business transaction contexts.
- Restricted Stock – Restricted stock is often used instead of options as it offers greater tax efficiency. Restricted shares are granted up front, but that up-front ownership is subject to restrictions that lapse over time. These shares allow the recipient to make an election under Section 83(b) and pay a small amount of taxes upfront so that they can access the lower capital gains rate on any future profit.
#3 Share Counts
This is the number of shares that come under various categories based on their use. These categories include:
- Authorized Shares – These are the shares that the company can issue and is set when the company is formed and mentioned on the company’s certificate (or articles) of incorporation. Initially, the number of shares offered is low but as the company grows, you can get more shares to issue.
- Outstanding Shares – These are the shares that have been issued and are still held by the shareholders.
- Shares Reserved for Stock Option Plans – These shares are also referred to as the “pool”. They are not outstanding shares but reserved and put aside for the company to issue later on when stock options are exercised.
- Remaining Unissued Shares – These are the leftover authorized shares that the company can issue and has not been reserved. It is a good thing to have a small number of remaining unissued shares to issue additional stock to a new co-founder or to reserve more shares.
- Fully Diluted Shares – This is the number of shares that would be outstanding in case all the possible sources of stock were converted or exercised. For instance, when stock options are granted for all of the shares reserved in the pool, and all of them are exercised, they are considered fully diluted. The shareholders would like to see their ownership expressed in terms of fully diluted shares to get the value of their ownership.
Cap Table Anatomy
With the startup cap table structure clear, let us understand this better with an example. Here is an example cap table with some explanations below to help you understand more.
|Key Terms||Amount||Shareholder||Pre-Money Shares||Pre-Money % Ownership||Investment Amount||Post-Money Shares||Post-Money % Ownership|
|Post-Money Valuation||$5,000,000||A Investor||0||0%||$750,000||1,500,000||15%|
Here, you can see all the main elements of the table including the shareholders, how much shareholders paid for shares, the percentage of ownership they have based on the pre-money and post-money valuation, etc. Let us understand the numbers better starting with the post-money valuation.
The founder discussed the term sheet with the investor and agreed on pre-money valuation and how much money will be raised. The total of this gives the post-money valuation. Here the post-money valuation is: $4,000,000 + $750,000 + $250,000 = $5,000,000
The next thing that is also automatically calculated during the term sheet discussions is the price per share. This tells how much the investor would pay for the number of shares they are getting. The price-per-share is simply the pre-money valuation divided by the number of pre-money shares, which is: $4,000,000/8,000,000 = $0.50
The total number of investor shares comes from dividing the total investment amount by the price per share. This would be equal to: $1,000,000/0.50 = 2,000,000
- Investor A shares would amount to: $750,000/0.50 = 1,500,000
- Investor B’s shares would amount: $250,000/0.50 = 500,000
Investor percent ownership is calculated by taking the investor shares from above and dividing them by the post-money shares. So:
- Investor A’s percent ownership would be: 1,500,000/10,000,000 = 15%
- Investor B’s percent ownership would be: 500,000/10,000,000 = 5%
Each of the main terms on the cap table come from one another and are driven primarily from the term sheet discussions. But to sum it all up, here are the formulas you will be using:
- Post-Money Valuation = Pre-Money Valuation + Total Investment Amount
- Price-Per-Share = Pre-Money Valuation / Pre-Money Shares
- Post-Money Shares = Post Money Valuation/ Price-Per-Share
- Investor Percent Ownership = Investor Shares / Post-Money Shares
How do cap tables evolve over time of an early-stage company?
When a company is incorporated, the startup cap table is very simple. Let us assume that there are only two founders in the company. It would just have these two, simple! Over time, the startup cap table structure will become more complicated when more shareholders are added to the company.
Let us put the changes in two groups as explained below:
#1 Employees, Directors and Advisors
The company will obviously add employees as it grows along with advisors and directors. And let us say that the founder decides to give out warrants, restricted stock awards or options to incentivize or retain these people. In this case, it would be added to the cap table since we are talking about shares here. Here are events that will change the startup cap table structure:
- Establishing an option pool (mostly 5% to 25% of the total authorized shares leads to a new line of options)
- Increasing the size of the option pool (get more authorized shares and increase in the pool line item)
- Issuing a warrant, restricted share award, or stock options to an individual worker (new line item for the options and the reduction in size of remaining pool)
- Exercising of warrants or options by an individual (reduction of their option listing – this also leads to the increase in the common stockholder list and common shares outstanding)
- Terminating expired warrants, unvested restricted share awards or unvested options when an individual’s service to the company ends before they vest (removal of an option line item, the return of those shares to the pool – if the company wishes it to be)
- Any transfer of shares between an individual and another entity like an investor or the company (a boost in shares issued and a new line item for that investor)
#2 Investors and Creditors
Many of the early-stage companies raise capital from a lot of different sources over time. The capital raised takes the form of either equity (partial ownership) or convertible debts or straight debt with warrants (lender). Whatever the case is, the information is added to the startup cap table structure and changes it. Here are the events that change it:
- Selling new shares of existing securities such as common shares (new line item for that shareholder and a reduction in the pool of authorized but unissued shares)
- Selling new shares of a new security such as a new class of preferred shares (creation of a new class, and new line items for the new investors)
- Issuing convertible debt, which doesn’t result in the immediate issuance of shares, but the information has to be recorded as it will convert in the future (new line item to reflect this debt and signal its potential impact for full dilution calculations)
- Issuing warrants as part of either a debt or equity round of financing (new line item, possible reduction of the option pool if the warrants use the pool)
How a Cap Table helps in funding a startup?
It is very important to understand the startup cap table structure since you will need to have it ready as soon as you open your company. Why? Well, if you want to grow your company, you will need investors to help with capital. For this, the investors would want to see your cap table before they invest in your company. They want to know who are the key people in the company and how the control structure is. All this is learned about from the cap table.
If you are able to show the investor a clear startup cap table instantly when the deal is in process, it builds confidence and trust. If you do not have one, it would just prove that you are not prepared and it may jeopardise your deal. You might lose the investment or have your company put at a very low value. It can cost you much more than you expect.
The cap table acts as a financial projections sheet as well. It helps you determine what amount of funding you need and how much equity you can afford to give out for it without you losing too much of your ownership in the company. It helps you make all the important decisions of your company from granting options to taking outside funding. In short, it helps you get the right amount of funding and with the best deal possible.
Understanding Convertible Notes? How do they impact a Cap Table?
You might have seen the mention of convertible notes above. Well, it is important to understand them too as they do affect the startup cap table structure a lot. Convertible notes are debt where the debt is paid in equity. Common convertible notes are KISS (Keep it Simple Security) and SAFE (Simple Agreement for Future Equity). These notes actually convert into shares of the company sometime in the future after it is granted. So, it is a blend of both equity and debt. And even though it is converted or not, it is very important for the cap table.
If you remember as was mentioned previously, that in any liquidation situation, the debt holders are paid first and then the preferred shareholders. So, before you can give out convertible notes, it is important to see how large the slice is in your offering. And for this, all the debt is recorded in the startup cap table. These details are included as well to ensure you know how much you are giving:
- The date the debt was incurred
- Amount of indebtedness
- Interest rate
- Interest rate calculation mechanism (annual, semi-annual, cumulative, non-cumulative)
- Maturity date (due date)
- Terms and conditions driving conversion.
Once these are discussed, there will be more discussions on the negotiated cap on the conversion price or discount against the conversion price if the deal features a cap or discount. All these terms affect the amount of ownership the shareholder would get when the convertible note will convert. And this affects the startup cap table a lot. Not just that, it is important to keep track of what you are giving out and the best way to do is through a cap table structure.
By now you know the various parts of a startup cap table structure and why they are important. So, using this knowledge, start off your journey as a founder on the right foot. Have your cap table ready before it gets too late. And a great and simple way to create your cap table is through a cap table software.
Eqvista is a FREE cap table software that you can try out. It offers everything you need from tracking shares to the compliance of the various equity rules. Check out the application here to know more.