Do your research before investing in any firm or startup. One must research the company’s past performance, future forecasts, and market valuation. A capitalization table (cap table) can help here. Having access to all of your company’s data, current and historical, is incredibly valuable when valuing or calculating employee equity interests. This article will provide a brief overview of a great technique for entrepreneurs to record and manage data. For investors, this article will highlight certain factors to consider before investing in a company.
For every startup, keeping track of their financing and stock distribution percentages is highly imperative. These things especially come in handy when carrying out a valuation. Let’s find out more about the intricacies of a cap table for startups.
What is a cap table?
A capitalization table, or cap table for short, is a list of all the stock that is available or issued by the company and tells you how much percentage of a stock is owned by a particular party (which can be an individual or a group of investors associated with the company).
When one starts a startup, its ownership often changes as it continues to grow and witnesses multiple funding rounds. Let’s say a new investor buys a sizable chunk of the company share, or a stock option gets exercised or when convertible notes are translated into stocks. A cap table keeps a record of all such data and tracks the transfer of ownership and stakes as the company grows.
Why do startups need a cap table?
A cap table helps you to determine all the stockholders in the company. This tracks all the members who have had a potential influence on the company and also tells you about the possible effect of fundraising rounds and shares issues likely to occur in the future.
Secondly, a capitalization table comes into use when drawing out company valuation under section 409A of the Internal Revenue Code. This lets venture capitalists carry out their independent valuation to showcase a fair market value for a particular stock.
Lastly, these tables come in handy in liquidity events when carrying out a waterfall analysis(a parameter that enlists the exact payouts to each shareholder on the cap table of an organization based on the equity available to them in a particular liquidity state) or scenario modeling of capital distributions.
Usually, the returns earned by various lenders, stockholders, and investors have a huge disparity between them. The capitalization table helps them identify their return rates.
Example of the cap table
Before looking at a sample cap table, note that showing the percentage ownership of the issued shares on a fully diluted basis is mandatory for a non-biased disclosure.
In this case, let us take the example of a specific company, X founded by three people A, B, and C. If we assume that the startup has created a total of 10 million shares, out of which 72% of the shares are evenly split between the co-founders. 20% is left for future investors, whereas the remaining 8% goes to employee stock options. Here is a tabular representation of the given data :
Given that a cap table is one of the most critical documents in the company, it needs to be updated on a regular basis. However, it is often riddled with plenty of errors due to constant changes. In order to ensure that it is error-free when being checked by potential investors and accountants, here are a few mistakes that you can avoid :
Mistakes in finalizing the deals
Not recording a deal or putting it on paper is one of the worst rookie mistakes an entrepreneur can make. Even though there are people who are true to their word and don’t need to put things on paper, a practically straight-minded business person will always record all the details of the agreement in the cap table and company records.
Verbal agreements are not always reliable, and it is always better to note down the details of all deals on paper or feed them in any mobile/desktop application once the deal is made.
Vested shares of founder
When founders start a company, they usually have a common set of goals and ambitions in mind when starting out. With time, differences arise between partners or say a certain member wants to leave the company on good terms.
If this ends in bad faith, you do not want a member with a substantial share of your company to walk out and put it all at stake. This is where the concept of vesting comes into play.
The shares have to be earned, which depends on the time served by a certain founder at the company. By this, if a certain director decides to leave before that decided period, his/her uninvested shares are diluted among the other members.
Not correctly analyzing the financing round impact
Knowing about all the tools and terms like participation caps, liquidation preferences, and participation rights is essential if you want to get appropriate financing on the table.
These changes should also be represented in the cap table. Many entrepreneurs often put forward a higher value when negotiating terms that could have been avoided if they had known the tools and software (like Eqvista) that allows you to manage your cap table with ease.
Not utilizing your options soon
Incentive stock options can grant lots of tax benefits if exercised at the right time. When these options are used, the user is also exempted from paying any kinds of taxes unless the stocks are sold.
If you hold these shares for the long term (over one year), then you will just have to pay long-term capital gain taxes, which are considerably lower than what you would pay for the same amount in your usual tax slab.
Raising too much capital in the initial stage
Even though the idea of getting funds might sound enticing, one should never take more than what they require. This is due to the fact that you can totally lose the ownership of your company since the power majorly lies in the hands of stakeholders now.
Having a properly updated cap table will allow you to decide the right amount of investment that is required while not giving enough to stake the ownership of the company.
Poor record of documents
Proper storage of data in the right channels is crucial when giving out the benefits such as compensations and equity to holders.
For instance, if you store and manage all your data in a spreadsheet and do not keep the cap table updated with all the legal records, agreements, and documents, then even a lawyer might find it difficult to advise you on how you should be distributing your shares.
Fail to negotiate exercisable options early
Just as cashing out your options too late might cause tax implications, the same may happen when the options aren’t exercisable early on.
What this does is that it allows you to use the uninvested stock and allocate them to restricted common stock. If your options can be used at an early stage, then it allows you to use the unvested and vested options at any time. However, it is worth noting that the same shares will have a lower tax rate after a year or two.
Negotiate option pool pre-money
When a term sheet parameter is mutually agreed upon, it typically has a requirement for an option pool distribution determined in the cap table. But the time at which this percentage is determined makes a huge difference.
For instance, negotiating an option pool pre-money instead of post-money would mean that in case you wish to incentivize people to develop the business, the current stakeholders will lose their share of the equity. And if you do not issue enough pool options, then the shareholders might get hold of a higher number of shares as compared to what they invested for.
In a scenario where you need to remove the option pool pre-money, make sure that you use all the options to obtain the entire value of the pool.
Insignificant cost of option grants
In accordance with the 409A laws, an issued option’s price should always be equal to or higher than the market value of its parent stock. In case you give the stocks at a lower price, you may land in problems when your company undergoes an acquisition leading to additional expenses and tax penalties.
On the other hand, if you grant the options a high price, your employees might get an undervalued stock. To avoid this from happening, consult a well-known 409A valuation provider.
Cap table management is a complicated task due to the multiple variables involved. Aside from the common mistakes startups do with their cap table, below are some errors that can be made by the management while updating/creating a new table:
Not having clarity about all the legal clauses when closing in on a deal might result in substantial losses later on if things do not go as planned.
Very often, startups skip taking a serious legal counselling session in order to save on expenses. What they fail to realize is the repercussion of this ignorance which can be seen in some cases which feature unexpected equity dilution, discrepancies in names and dates, etc.
Relying on spreadsheet
Spreadsheets are a great way to organize data when you have fewer stakeholders in the company. However, as your company starts to grow and expand, it will get more funding and issue grants to star performers on a frequent basis.
Using the right tool which can help you navigate through and manage all your data will safeguard you from having any technical problems later. Improper maintenance of documents might also lead to issues and dilemmas amongst stakeholders regarding their company holdings.
Operational issues mistakes
These refer to the minute and intricate details of the cap table that can be missed when it keeps getting updated regularly. Problems like not tracking terminations, transactions, and exercise windows might arise if you make errors while updating the cap table.
Now that you know all about the mistakes you can make with your cap table aside from its significance, it is only wise to shift to a cap table management tool or platform that automates the entire process and helps you keep everything in check with the touch of your fingers.