Why should you manage your cap table for an exit?

Exit plans are essential for securing a business owner’s financial future, but many only consider creating one once they are ready to leave. Business owners must consider an exit strategy but are frequently overlooked until significant changes are required. Entrepreneurs risk limiting their future options if they do not plan an exit strategy that informs business direction. Plan your exit strategy to ensure the best possible outcome for your company. If a company is doing well, an exit strategy should maximize profits, while an exit strategy should minimize losses. A good exit strategy will protect business value and provide more opportunities to optimize business outcomes. 

In this article, we shall understand cap table, exit strategy, cap table for strategy, manage your cap table for investors, manage cap table for an exit, investors rights, company exit, and cap table in depth. 

What is a company exit?

A business exit strategy is for transferring ownership of a company to another company or investors. Even if an entrepreneur is making a good living from his business, there may come a time when he wants to leave and try something new. When that time comes, the company can be sold, passed on to new management, or acquired by a larger corporation. Even if it is decades before the entrepreneur can sell his company, what he does now can make the process easier or more difficult.

How is a company exit structured?

An exit strategy is frequently thought of as a way to end a business, which it can be. Still, in best practice, a plan moves a business toward long-term goals. It allows for a smooth transition to a new phase, whether that involves re-imagining business direction or leadership, remaining financially sustainable, or pivoting for challenges.

A well-developed exit strategy considers all business stakeholders, finances, operations, and all actions required to sell or close the business. Exit strategies, depending on the type and size of the business, differ. However, firm plans recognize the company’s actual value and lay the groundwork for future goals and new directions.

How does a Cap Table work? 

Venture capitalists (VCs), entrepreneurs, investment analysts, and investors use cap tables to help them make critical financial decisions and assess a company’s market value. A cap table can help you figure out things like:

• What percentage of the company is still owned by the founding team?
• How much of your potential equity stake in the company may be diluted in the next round of funding
• Who are the primary stakeholders in a business?
• Whether or not a startup uses stock options to motivate employees- as well as how much and much more.

What do investors look for in your cap table for investment & possible exit?

Capitalization or cap tables are among the most important documents for an entrepreneur to understand. A cap table shows who the shareholders are and how many shares they own in a company. Although this appears to be a simple exercise, it can become increasingly complex as a company grows to keep track of all shareholder information, ownership positions, future rights to purchase additional equity, vesting schedules, share prices, voting percentages, and preference clauses. 

Furthermore, the cap table is an essential decision-making tool in crucial events such as financing, ownership, and exit. This is also why investors closely examine a cap table during the financing process. There are several ways its composition can deter investors (also known as a “broken cap table”):

• Number of shareholders – The most concerning part is about the founding team if it’s a single founder, two or three co-founders, advisors and so on. One of the most serious issues is the founding team’s lack of ownership. An inexperienced founder eager to secure the first equity investment may give up too much equity too soon, whether to angel investors or through multiple seed rounds. This may later prove to be a barrier for new investors, as it raises questions about whether the founders still have enough incentive to perform at their best. There are no specific regulations, but a venture enters the danger zone when the founding team (including ESOP) has less than 50%, with the CEO’s share less than 10% after the seed round. Simple preventative measures include being cautious of dilution in the early stages of the company and limiting the number of bridge rounds (i.e. raising adequate amounts).
• Number of previous investors (and their rights) – Regarding cap tables, the phrase “the more, the merrier” is relevant. Large numbers of investors (20 or more) can be a major distraction, especially if a founder must spend a significant time acquiring signatures, aligning interests, and informing all parties. New investors are typically uninterested in participating in a venture dealing with these dynamics, especially since negotiating future ownership stakes and strategies with many small owners entails significant risk. Limiting the number of investors on board and/or pooling smaller investors in legal entities with a single representative is in the founders’ best interests.
• Number of equity classes – Dead equity is defined as substantial equity stakes (>2%) owned by co-founders, advisors, and management teams no longer involved with the company. Granted equity stakes to individuals not actively growing the company easily leads to management misalignment, which becomes a problem for investors. Fortunately, dead equity can be easily avoided by including the appropriate terms and conditions in shareholder documentation, like vesting schemes or buyback provisions. Also, avoid giving away equity stakes to third parties in exchange for one-time contributions.
• Amount of SAFE notes – SAFEs and convertible notes (also known as convertible debt) are two of the most common securities available through equity crowdfunding today. While they differ slightly, they are fundamentally the same. SAFEs and convertible notes are essentially contracts that entitle the investor to stock in the company if and only if a predetermined “trigger event” occurs.

Order of payouts

When preparing for an exit, it’s important to remember the proper order when dealing with payouts. Here is the order of payouts when dealing with an exit:

• Debt holders (Debt and SAFE notes) – Debt holders would be paid out first in case of a company exit or company acquisition. The reason is that debt has priority over equity investments (think of credit holders), so all debt holders would be paid out before the preference shareholders, common shareholders and options/warrant holders.
• Preference shareholders (investors) – Preferred shareholders get dividend payments earlier than common shareholders since they have a preference for the company’s profits. The primary distinction between the two types of grants is stockholders’ voting rights, which preference shareholders don’t have. 
• Common stockholders – Common stockholders will get distributions last after debt holders and preferred shareholders. However, they have a right to vote in case of key decision-making in the business. 
• Option and warrant holders – For option and warrant holders, they will only be paid out if the total payout per share is higher than their exercise price. If so, they will participate with the other equity holders (debt holders, preference shareholders, common shareholders) and gain profit on the difference between the share price and their exercise price.

Investor rights 

Every prospective investor has the right to be fully informed of all relevant information, including the benefits, risks, and costs of the investment in concern. 

• Liquidation rights – The board of directors must appoint the company’s first auditor. Furthermore, the shareholders must meet during the annual general meeting as per the recommendation of the board of directors and the audit committee. The appointment is usually five years and can be extended at the annual general body by passing a resolution.
• Participation rights – Existing investors’ right to participate in the following funding rounds is a participation right. This participation right, also known as a pro-rata right, is often only available to significant investors and may appear in the seed stage.
• Director’s appointments – With the passage of an ordinary resolution, shareholders have a direct role in the appointment of directors. Aside from that, shareholders can appoint different types of directors. They are as follows:
  • A second director who will serve until the next general body meeting;
  • An alternate director who will serve as such for a period of three months;
  • A director nominee;
  • A director is appointed if there is a casual vacancy for any director at a general public company meeting.
• Voting rights – Shareholders can also attend the annual general body meeting and cast a vote. Every company is required to hold at least one annual general meeting. Various mandatory agenda items are discussed at the meeting, such as the adoption of financial statements, the appointment or ratification of directors and auditors, and so on. When members of a company propose a resolution, it can only be passed through shareholder voting in one of the following forms:
  • Voting by showing one’s hands
  • Polling places are used for voting.
  • Electronic voting is used.
  • Using a postal ballot to vote
• Right to call for a general meeting – Shareholders can call a general meeting. They can also approach the Company Law Board if the statutory requirements do not hold general body meetings.
• Right to inspect registers and book – Because shareholders are the primary stakeholders in a company, they have the right to inspect the company’s accounts register and books and ask questions about them if they so desire.
• Right to take legal action against the directors  – Shareholders are allowed to file a lawsuit against the director based on the following:
  • If the director took action in any way that is detrimental to the company’s business
  • any action taken that is illegal or unconstitutional.
  • Deception or fraud.
  • If the assets of the business are moved at a discounted price.
  • Whenever the company’s finances are diverted.
  • Any act carried out in bad faith.
  • The selection of corporation auditors

How to effectively manage your cap table for the best exit

Your company’s various numbers, rows, and columns also provide a claim to the company’s monetary value. Small percentage differences when a company is valued in the millions or billions of dollars can significantly affect the check you will receive upon a successful exit of your company.

Rather than simply examining the status quo, the cap table is frequently used to run future scenarios. When VCs consider investing in a company, they typically use the “VC method” of valuation to validate their participation. Taking into account the company’s terminal value (also known as “exit value”) and the fund’s ROI target, the required stake (%) is calculated during the funding round and pre-money valuation. 

The fundamentals are straightforward and extremely useful for a founder to understand to ensure that when formulating a capital request, it is in line with investor expectations. Please keep in mind that the math can become quite complicated when factors such as dilution from subsequent rounds and downside protection are considered & time-value of money comes into action. 

Manage your company cap table on Eqvista! 

Utilize Eqvista to manage your business’s cap table and valuations! Whether you run a modest startup or a huge organization, Eqvista offers services and packages to meet your business’s demands, including integrated cap table management and limitless 409A valuations. With our Freemium plan, you can get started for nothing and upgrade your account as your business develops. Contact us today to learn more!