By: Benjamin Jacob
MASTER OF THE CAP – WHAT IS A CAP TABLE & WHY IT MATTERS
A cap table – or capitalization table – is an essential corporate document particularly important in a venture-backed growth startup or any other business that has a fluid ownership structure. Investors and acquirers alike will scrutinize the cap table and its various potential post-transaction permutations as a key diligence item central to the decision on whether to invest in or purchase your company.
To be prepared for exhilarating growth or a spectacular exit, founders should master their cap table – past, present and future – in order to plan well and make key strategic decisions when the time comes. Failing to invest the time upfront to master cap table basics and how to properly leverage your cap table can lead to unexpected, painful results and deep regret.
WHAT IS A CAP TABLE – THE BASICS
A cap table essentially provides a breakdown of the ownership of a company. Historically, this was typically documented in an Excel spreadsheet. Today, digital ownership and equity management platforms like Carta, Pulley, and others have ushered in a new era of modern cap table management.
A cap table, regardless of form, should detail who owns what today. This involves detailing the total authorized number of shares the corporation may legally issue and all of the issued securities of a company including shares of common stock and preferred stock, stock options, and warrants. Although not technically included on the cap table, the company will need to have ledgers (which are normally connected to the cap table) for SAFEs, convertible notes, and any other convertible securities issued.
Fully diluted cap table.
A “fully diluted cap table” includes securities such as warrants and options that have been issued but for various reasons have not yet been exercised into shares of stock to be issued by the company. Including this level of detail provides a full view of the company’s ownership structure by showing what the company’s ownership will look like in the event options or warrants are exercised. This information is critical both for founders and investors alike so they can make decisions on investment with a clear understanding of impact on ownership percentages, voting power, and likely return on investment.
Pro Forma cap table.
A pro forma cap table builds upon the information provided in a fully diluted cap table by showing the company’s ownership before and after an investment (e.g., Series A financing, post-acquisition, etc.). The pro forma cap table is a critical transaction document because it shows the ownership percentages for all stockholders (including founders and new investors) once the transaction closes. Once a term sheet is signed, building the pro forma is typically the first major task for a company’s legal counsel or financial advisor. The basic terms agreed to in the term sheet (along with the terms of previously issued convertible securities like convertible notes and SAFEs) will inform how to construct the mathematical equations to show the future intended capitalization.
Pre-Money & Post-money
The pre-money valuation states the value of the Company prior to receiving funding (e.g., a venture financing) whereas the post-money valuation states the value of the Company immediately following receipt of investment funds. To reiterate, a post-money valuation is essentially the pre-money valuation plus the amount of capital raised in a financing, but it can get a little more complicated when there are previously outstanding convertible securities involved in the deal, an option pool refresh, or a secondary transaction with the founders.
To recap, a cap table, particularly a fully-diluted cap table and/or a pro forma cap table, should include:
- Authorized shares
- Issued and outstanding shares
- Unissued shares
- Stock options including allocated and issued
- Detailed list of stockholders
- Valuation details such as a pre-money valuation and amount of new capital raised
WHY IT MATTERS
Founders that invest the time to understand their cap table and manage it adeptly will be well-positioned to make better decisions in terms of managing the various relationships in the company, deciding if/when to issue equity compensation as well as being prepared to raise future financing for the company since investors will scrutinize the cap table dynamics as a fundamental consideration as to whether to invest.
Investors understandably will scrutinize the pro forma cap table modeling potential investment in the company to fine-tune their anticipated investment amount against the investor’s target return as they eye future exit scenarios such as a sale of the company or an initial public offering (IPO). In addition, the pro forma provides investors important information as to who has already invested how much money in the company. Furthermore, as part of any financing, investors and founders often wrestle with the option pool as a critical negotiating point given investors’ interest in ensuring they are investing in a company that is well-positioned to attract and hire top talent.
Cap tables often move from simple to complex as the company progresses and raises additional rounds of capital. Convertible securities and terms of conversions can be a source of great confusion because of the denseness of the underlying calculations that flow from the conversion mechanics detailed in the convertible security instruments themselves. Founders should invest time upfront particularly on convertible securities and their impact on future ownership to ensure they can make sound decisions on whether to sell more or less convertible securities as the company requires more capital.
In summary, a cap table is the primary document that describes a company’s ownership breakdown. A fully diluted cap table shows ownership broken down if all options or convertible securities are exchanged into shares of common or preferred stock while a pro forma cap chart models out ownership of the company before and after a capital investment. A strong understanding of cap table basics is essential for a founding team to plan well for the company’s long-term growth. A strong relationship with trusted legal counsel can help founders get comfortable and ensure the company manages its cap table correctly avoiding mistakes that can slow or sink an otherwise promising future venture financing.
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