Importance of Cap Table in Venture Capital

A startup’s venture capital cap table can initially be fairly simple, consisting solely of the founders and/or the first few workers. However, when the company’s staff base grows and additional outside investors become involved, the situation can quickly become more problematic.

As a result, a cap table must be employed and maintained to determine the dilutive effect of each fundraising round, employee stock options, and new securities issuances. Hence, all stakeholders may precisely estimate their respective shares of the proceeds from a future exit (i.e., liquidation event such as a sale to a strategic or IPO). We’ve mapped a brief on the importance of a cap table for venture capital and its need for VC for your better knowledge. 

Cap table and venture capital

Cap tables are an extension of the venture capital term sheet for venture capitalists by keeping track of the company’s ownership structure. Here is more elaborative info on the cap table and venture capital.

What is a Cap table?

A cap table is a spreadsheet that displays all the company’s securities (common shares, preferred shares, warrants, etc.), who has them, and how much they cost the investors to acquire them. Investors may see how much of a stake they have in a firm and how that stake has changed over time by looking at the percentage of ownership each stakeholder has. In the early phases of a startup or venture, cap tables are established before any other company documentation. There is a lot going on in a cap table after a few rounds of fundraising, including initial public offerings (IPOs), mergers, and acquisitions.

In order to evaluate important events like ownership dilution, employee stock options, and the issuance of additional stocks, venture capitalists and investment analysts use cab tables.

What is the VC cap table?

In short, cap tables are used by venture capitalists to track a company’s stockholders in terms of the number and kind of shares (as well as the series), along with any special provisions, including liquidation preferences or protection clauses.

How does the VC cap table work?

Initially, most capitalization tables are built using a spreadsheet. You can also construct it on dedicated software. Now, however, in the mode you wish,  your cap table will work based on these elements:

• Ownership stake – Who owns what percentage of the company (investors, founders, or employees)? Most companies require a voting agreement between preferred and common shareholders for procedural company decisions. The section will also include a list of stockholders and their shareholdings.
• The types of shares indicate who has common shares and who has preferred stock options.
• A cap table often contains debt that can be converted into equity. It is fully diluted in all ownership calculations. Calculating debt on a fully diluted basis assumes all outstanding options, warrants, and convertible notes have been exercised.

Depending on your business needs, you may want to include more variables in your cap table:

• The overall cost of a business’s shares.
• Total allowed shares, i.e., the total number of shares you are permitted to sell.
• The total number of outstanding shares is as follows: The total number of shares owned by stakeholders in a business.
• Shares reserved for employees, i.e., the total number of shares reserved for employees.

How often should the cap table be updated?

The cap table is updated following each investment round unless otherwise specified in the term sheet. Several major factors that change on the cap table following a new investment round include the following:

• Calculation of the market value and the price per share
• New investors and/or asset classes (e.g. Series B Preferred)
• Employee stock options and warrants (either allocated or unallocated)
• Converted debt to equity

VC cap tables can also be updated if investors and/or personnel leave the firm; however, the majority of changes to the cap table are dilutive, implying that as additional investors join the company, the equity ownership % of each entity will fall. Dilution is permissible as long as the company’s valuation continues to rise (referred to as an “up round”).

For instance, a cap table may start with the founders and key staff, then venture capitalists, and finally, angel or minority investors such as family and friends. Additionally, a cap table may rank all stakeholders according to their ownership share, often from largest to lowest.

On a standard cap table, the individual or firm’s name is listed in the first column, their shares are listed in the second, and their ownership percentage is displayed in the last column. Additionally, the date of investment might be specified.

A typical cap table includes all shares on a fully diluted basis, which means that all shares are included even if they have not yet been awarded or earned. Additionally, a cap table may contain unallocated options that will be allocated as key workers are hired in the future.

Cap table in venture capital

VC firms use the Cap Table to keep close tabs on the current capitalization (i.e. equity ownership) of startups and venture-backed businesses. Uses of VC cap tables where and how are the VC cap tables interrupted? Let’s see.

Where is the VC cap table used?

A cap table can be used for a variety of purposes in addition to displaying current equity ownership:

• Analyzing potential pre-money value scenarios for a possible next round of investment by existing investors
• When new investors or potential acquirers should do a thorough background check.
• Constructing 409A values and looking for any unallocated hiring alternatives available.
• Exit valuation assumptions are used to do an analysis of expected returns and proceeds to various sources of capital.
• Compliance with the law and taxation.
• When a firm is sold or goes public, the VC cap table is no longer relevant.

For fresh fundraising, prospective VCs and investors want to know how a company is owned and what changes have been made in past financing rounds. The cap table may be able to answer some of an investor’s questions. New investors, for example, will want to know how their investments would affect other investors, as well. As a result, they wish to avoid conflicts with other investors that could lead to litigation. The liquidity ranking is also an important consideration for investors. In the event of a liquidity event, they want to be paid out ahead of other investors. So, a cap table is primarily used when a company is about to secure funds or investments from VC or investors. 

How is the VC cap table calculated?

A VC cap table’s equity ownership should add up to 100% at the most basic level. For example, if new investors are added, or debt is converted to equity, the cap table’s share count needs to be adjusted to reflect these developments while being 100% accurate.

Let’s take a look at an example of how to do the computations needed to calculate the cap table:

• For example, let’s say a venture capitalist offers to invest $1 million in exchange for a 10% stake in your company.
• There are currently more than 100,000 shares of the firm outstanding (50 percent held by the founder and 50% held by an angel investor)

How many new Series A shares does the new investor receive as part of the investment?

Applying the assumptions:

• New Shares = [.10/(1-.10)] * 100,000
• New Shares = 11,111

By performing the computation, we can determine that their shares account for 10% of the new company:

• 11,111 / (100,000 + 11,111) = 10%

Waterfall analysis and VC cap table

After an acquisition, the waterfall flow of funds demonstrates how each stakeholder on a company’s cap table receives their share of a liquidity event’s proceeds.

After investing $1 million in an investment that was previously split 50/50 between the founder and an angel investor, let’s assume the company sells for $5 million, or nearly half of its initial valuation, five years later and share those proceeds accordingly.

Some more info:

• The Series A Preferred shares provide a 1x liquidation preference for non-participating holders.
• The preferred to common conversion ratio is expected to be 1:1.

To begin, the Series A investor must pick whether to retain their preferred stock (1x their initial $1 million investment) or convert to common stock and get their pro-rata share of the proceeds:

• $1 million is the amount of the preference.
• The conversion factor is 10% of $5 million, or $500,000.

Clearly, the VC will choose a 1x multiple of invested capital, which ensures that they receive their money back, but this would be regarded as a loss on a time-valued basis. Each founder and angel investor would receive $2 million.

Now, What if the aforementioned company were to sell for $100 million?

The investor would then convert to common stock and get $10 million, or 10% of the proceeds, while the founder and angel investor would each receive $45 million. 

VC-Specific Best Practices

When reviewing cap tables from potential portfolio companies, venture capitalists should follow these best practices:

• Request a current and comprehensive cap table – The cap table should be up-to-date and include all equity holders, including founders, employees, advisors, and previous investors.
• Analyze ownership percentages – VCs should examine how ownership is distributed among founders, employees, and existing investors. They want to ensure founders still own enough of the company to remain motivated and that there’s sufficient equity available for future employees.
• Review the option pool – Check that an adequate option pool has been set aside for future employee equity grants. This is important for attracting and retaining talent.
• Examine previous funding rounds – Look at the terms and valuations of prior investments to understand the company’s funding history and trajectory.
• Verify accuracy and consistency – Cross-reference the cap table with other documents like stock certificates, option grants, and convertible notes to ensure all information is accurate.
• Use cap table software – Encourage companies to use dedicated cap table management platforms rather than Excel spreadsheets to reduce errors and version control issues.
• Consider future rounds – Assess how the current cap table structure will impact potential future funding rounds and exit scenarios.
• Maintain confidentiality – Treat the cap table information as confidential and have appropriate non-disclosure agreements in place.

When reviewing a cap table, venture capitalists should be careful of several red flags that could indicate potential issues with the company’s equity structure and management.

Cap Table Red Flags

• Messy Cap Table – A cap table with too many stakeholders can be a sign of complexity and potential administrative challenges. This can slow down decision-making and complicate future fundraising efforts.
• Inaccurate or Outdated Information – Cap tables that are not regularly updated or contain errors can lead to legal and financial risks. Investors should ensure the cap table is current and accurate.
• Excessive Founder Dilution – If founders hold a very small percentage of the company, it might indicate excessive dilution from previous funding rounds, which could affect their motivation and control over the company.
• Complex Ownership Structures – Multiple classes of shares or overly complex equity structures can be a red flag. Investors prefer straightforward share structures with clear ownership percentages.
• Unclear Option Pools – Lack of clarity around the size and allocation of the option pool can be problematic. A well-defined option pool is essential for attracting and retaining talent.
• Multiple Versions of Cap Tables – Having multiple versions of the cap table can lead to inconsistencies and confusion. There should be a single, authoritative version of the cap table.
• Poor Record Keeping – Incomplete or poorly maintained records of equity agreements, transactions, and shareholder details can lead to disputes and operational inefficiencies.
• Lack of Professional Oversight – Not consulting legal or financial professionals to manage the cap table can result in costly mistakes and compliance issues.

By identifying these red flags, VCs can better assess the health and transparency of a company’s equity structure, ultimately making more informed investment decisions.

Importance of cap table to get venture capital

The price per share and the pre and post-money valuation worksheet are essential parts of the cap table.

• Help in the pre-money valuation – The company’s pre-investment valuation is known as the P/E ratio. Negotiations between the company’s management and investors are typically required to set the valuation.
• Help in post-money valuation – The company’s valuation comes into play following an investment. For instance, if the pre-money valuation was $2 million and investors invested $1 million, the post-money valuation would be $3 million.
• Determine price per share – It is the computation that is made by multiplying the post-money valuation by the number of fully diluted shares. Therefore, if the post-money valuation is $15 million and we have 3 million shares, the price per share will be $5.
• Calculate authorized, outstanding and reserved shares – Also, it assists in the valuation of authorized and outstanding i.e., excludes ungranted and unexercised shares from the total number of shares that have been issued.

What do investors look for in the cap table?

Among the most vital components of your cap table, here are the 4 things investors look for:

• Investors count – They look for the investor’s count, as it’s a red flag for investors if the cap table has so many investors. Having a large number of investors can create risk for new investments because it can be distracting. Large stakes in a corporation are attractive to investors. 
• Team with long-term incentives – The Cap Table displays the capital contributions and ownership percentages made by various investors. The Cap Table will also include any equity-related activities that you’ve outsourced to a third party. Investors desire to see a whole team with long-term incentives to continue with the business. An undervalued team or an unfairly dispersed ownership structure raises the risk level.
• Future forecast – To ensure that the Cap table doesn’t include an impossible scenario in the future, here are three simple steps.
  • Look at who owns what proportion of the company and how much each investor demands in dollars in return for their investment.
  • Take a look at how much money the team can generate with the investment it has made so far.
  • Calculate the purchase value at a multiple of 6-8 times the revenue you determined in step 2.

 If you’re left with a negative number at the end of this process, the company model isn’t strong enough to handle that level of investment. There is no way that investors want to see negative returns as the only option.

• Equity distribution – Distribution of equity – who receives what at the end — is a significant factor. Using standard terminology makes things a lot simpler. Calculations can grow overly complex if each investor has their own unique terms, which creates risks.

Why do you need to maintain a clean and clear cap table? 

The Cap table should be maintained clean and clear as, beyond the information, the cap table will be a major factor in any potential investor’s decision, so it must be precise, well organized, consistent, and up to date.

Investors, for example, require updated information on all business stock matters. This includes the current ownership structure and possibilities for employees or capital contributors.

With each funding round, a cap table will need to evolve and get more complex. Greater investor participation entails greater dilution and shifting stock valuation. Against this backdrop, it should be evident that regardless of how easy or difficult it is to create a cap table initially, sustaining it over time is a constant challenge that must be met.

Errors in a cap table can lose you your funding round and thus your business.

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