It takes a lot to start a business. One needs a great idea, hard work, and innovation to achieve stable traction and growth. And as the company grows, it brings on new people and may decide to issue stock options to attract new staff and funding from investors. This is all incorporated into a document called a Cap Table.
A cap table will help you in the strategic management of business decisions. Wondering what a cap table is, its importance, and how you can maintain it to expand your business? Let’s dive in.
What is a cap table?
A cap table is also known as the capitalization table. This is a table that outlines the company’s capitalization. To be more specific, it is a list of all the shareholders and grants in a company. The use of a cap table for a company comes into play when it has to track the total amount of shares, the value of shares, and the equity ownership of all the shareholders.
The data of the company, such as debt and the company’s equity ownership, is laid out with the help of a cap table. Everything from liquidation rights of investors and total capital from lenders is listed in this cap table. Since almost all startups do not possess traditional debt lenders, the list usually consists of data of the shareholders and the percentage they own. Furthermore, there are various forms of equity, such as preferred stock, common stock, and convertible notes, which influence the present and potential future investors.
Why is a cap table important for a small business?
A company needs a cap table because decisions are made with the help of this cap table. For instance, the cap table will help you with various possibilities while running business activities like available options and pre-money valuations faster.
This can be helpful when you are hiring a COO for the company, and the candidate asks to get percentage ownership in the company. In case this option is not available, you may quickly discover how much you will give and calculate the percentage you are ready to offer. Basically, it illustrates who owns the company.
Another critical aspect of the cap table is that it represents money, a potentially significant amount of money for the company. The range of investments in a startup can vary from three to seven figures. Later, when the startup develops and becomes profitable, the value of that stock can double or triple. A tiny error on a cap table can mean a difference of thousands of dollars. Therefore a cap table is needed to maintain all of that. One can justify the importance of a cap table with the help of the following points:
- A Cap table allows potential investors to use the information to assess the amount of control and leverage they will get for their money.
- Current investors can check who has control and use the data to determine their position and potential profit with the help of a Cap table.
- Stockholders use the cap table to check the value of their shares in real-time.
- The data presents a historical insight on a cap table that can affect the valuation of your startup when it comes time for a new round of fundraising.
- It permits you to perfectly present the history of your company and holdings in the event of an audit.
- Founders can apply the information to instantly ascertain what percentage of the startup they have to propose a new investor.
By now, you know the value of a well-maintained cap table increases with time the longer your business exists. It is the key to success, and you must get it right from the very first time.
Basic elements of a cap table
Let us discuss the various elements that are used in a Cap table:
A shareholder is an individual or a corporation that owns one or more shares of the company. Shareholders are referred to as members of a corporation. Simply put, those shareholders who have bought shares of the company are listed on a cap table.
The authorized shares or the securities are the total number of shares that have been reserved for issuance by the owner of your startup.
Common shares are the most fundamental form of ownership in your company.
A class of stock with special rights as described in your startup is called preference shares. There are different types of preferred stock with their own set of privileges:
A convertible note is like a loan, but this amount can be converted into company equity later on, usually during a liquidation event, like the acquisition of the company. Investors get converted at the lesser of the valuation of the following qualified priced round and the convertible note cap.
Total share ownership
Total share ownership is the sum of the common stock, stock options, preferred stock, and any other stock category for a single individual.
Example of a cap table
Here you can see that the founders own most of the shares at 67.7%, then the ESOP (employee stock option pool) at 12.31 percent, and then the investors at 20 percent. It’s crucial to know what parties own how much before you pitch your company to new investors.
How to create a cap table
The cap table should be designed in a simple and organized layout that clearly shows who owns what shares and the number of outstanding shares.
There are two ways of creating a cap table:
Using excel sheet templates
Almost all organizations use spreadsheets to build a cap table at the start of the business. The most famous structure to create a cap table is to list investors/security owners on the Y-axis, while the type of securities is listed on the X-axis.
A spreadsheet template can be used by a company that permits adding information and figures related to their business. In this spreadsheet, the first row should designate the total number of company shares. The subsequent rows should list the authorized shares, outstanding, unissued shares, and shares reserved for the stock option plan and investors.
Here is an example of a cap table after a round of funding, with a pre-money valuation of $1 million. Here 20 percent of the company is split between the 3 incoming investors, with 4 percent going to Investor A, 6.4 percent going to Investor B, and 9.6 percent going to Investor C.
As the business grows, maintaining an excel cap table with many shareholders can be a massive hassle. With time as business growth takes place, the number of investors and classes of shares increases.
Additionally, more and more rows and columns are required. Recruitment of more employees will also need testing schedules and tracking the option grants, which will need formulas and more sheets. To overcome this hassle of adding more and more sheets, a cap table software is used that can do it all for you, no matter how big your company is.
Best ways to maintain a cap table for investors
Now that you know the ins and outs of what a cap table is and how it functions, here are a few of the best ways to sustain your cap table for investors:
1. Keep information up-to-date & record every detail
To make the best use of a cap table is to keep it simple and organized. Ensure that the cap table has to be up to date all the time. This means updating any changes such as bringing in new shareholders, transfer of shares between shareholders, stock option exercises, repurchase (buying back shares) of shares from the company, and other transactions. All these can happen on a daily basis and affect the total ownership of a company that each individual shareholder has.
It would be best if you had a well-organized cap table to make immediate and intelligent decisions about the company’s shares. Moreover, this is one reason where cap table software comes in handy and is preferred over the traditional excel cap table. Organize and maintain the cap table and the data in such a way that it stays useful, especially when pitching to new investors.
2. Include details of Convertible Notes on the Cap Table
The popularity of convertible notes is increasing in the world of startup financing, especially in seed-stage companies. It is attractive for seed-stage companies that have not had time to show much traction in terms of their product or revenue. Instead of giving investors a discount on the price set later, the company can push that decision back. This is why convertible notes are used as the first outside funding invested in many companies.
However, one major mistake of most startups is they forget to include the Convertible Notes on their Cap Table. Incoming investors make decisions based on the possible dilution of their investments on ownership and often find themselves surprised by overlooked convertible notes. What happens if a new investment of $1 million on a pre-money valuation of $5 million has $2 million in undiscovered notes? The new investor would be coming in with the assumption that they own around 20% of the company, when in reality it may be much less.
Why this matters
For example, let’s say the company has these $2 million in convertible notes previously undisclosed. As you may or may not know, convertible notes have many terms that can be preferential to the note holder to sweeten the deal for them to fund the company. One of these terms is the valuation cap, ie. the total amount their note would be divided by in case of conversion.
Let’s say these notes have a valuation cap of $3 million, as they invested early in the company. That would essentially mean that these noteholders get $2 million / $3 million, or around 66.67% of the total company shares. That means that the remaining 33.33% of shares would be fought over by the founders, employees, and the new investor. Depending on the math of the conversion, this investor would be getting far less than their expected 20%.
This is why it’s crucial to include the convertible note details on the Cap Table.
3. Outline your plans for future employee stock option pools
For any (early stage) startup, the team is the most critical asset. An employee stock option program, also known as ESOP, is one of the most effective ways to build a highly motivated team and solid work culture. A properly outlined ESOP can make or break your plans for future hires and exponentially growing your business. Thus take the time to outline your plan for future employee stock option pools, especially on how you want the options to vest.
4. Add pre-money valuation & calculation for it
As the name suggests, the pre-money valuation is the equity value of a company before it receives the cash from a new round. Adding this pre-money valuation to the company’s Cap Table while planning gives reference to the fair value of the shares, and how much the company should be looking for with new investors.
This pre-money valuation also gives new investors some reference on how much ownership% they will receive if they invest X dollars into the company.
5. Add details of possible dilution when bringing on investors
Dilution happens when a company issues new shares that decrease existing stockholders’ ownership percentage of that company. It is the reduction in shareholders’ equity positions by issuing new shares. Dilution can happen the moment a company raises additional equity capital, though existing shareholders are usually disadvantaged. Therefore, to maintain your cap table for investors, you must add details of possible dilution effects with bringing on new shareholders.
Ready to add investors to your cap table?
Now you know all about what a cap table is and how it affects the company. In the beginning, keep all the details of your cap table in excel. When you grow, think about putting the details into a sophisticated cap table software to simplify management and help you focus on what’s important—running your business.