Posted by Early Growth
December 30, 2016 | 8-minute read (1480 words)
As a financial services provider to a significant portion of startups nationwide, Early Growth Financial Services sees what it takes for a startup to organize and attract a large sum investment. One of the most central and yet overlooked elements is the management of the capitalization table, or "cap table" as it is often known. This backbone of equity transactions helps define what and who is involved, and crucially how all will benefit from each step forward.
The upkeep and the attention to detail a cap table requires can be burdensome. Despite that, keeping these records well-maintained can affect not only how significantly a potential investor will judge a company, but also how much control and leverage will be retained during negotiation. Within this study, we will examine some of the questions, and pitfalls, to be aware of that go with cap table management (CTM). Also, we will illustrate and offer clear options to consider in planning the steps needed.
Setting up a strong foundation for organizing CTM as well as spending time thinking beforehand of the various intricacies they involve is, and should be, a top priority for any focused and strategically-oriented founders.
Cap Table Management Options
When it comes to the cap table management, there are two basic choices.
The first choice is to self-manage. Usually this involves setting up and utilizing a software solution. One software package that is specifically suited and well regarded for this is from CapShare. CapShare software allows you to issue stock and manage the equity involved in a stream lined system that integrates records and spreadsheets for easy visualization and tracking.
More frequently the second choice is utilized, companies outsource all the work of cap table managing and maintaining to a dedicated legal team. Whichever of these options you go with all founders should have a legal partner help them initially form and structure their company's cap table.
There are some pros and cons to be considered. The most obvious downside to using a full service legal team is that it is costlier. Another major concern to be aware of is that you are subject to their timing for new issuances, changes, copies, etc. You also don't have an easy way to model potential exit or raise scenarios, that is simply not a service legal provides. With handing over of control, there is less work but more teams to manage.
The pro, however, would be that you have a subject matter expert who can ensure accuracy, compliance and answer questions along the way.
Managing the cap table, yourself, with a software solution, makes things more efficient and cost-effective. Furthermore, you don't have to work with legal and any of the potential bottle necks that go with that. Another plus is that most software solutions allow for online access to individual employees, shareholders, and other interested parties needing details on equity. All of that creates assurance and provides an added level of transparency.
One con to this approach is that founders without a good understanding of vesting, liquidation preferences, term sheets and other nuances of equity management could quickly and easily get themselves in trouble. Also, solo management with software poses the same limitation as using a legal team regarding an inability for creating various modeling scenarios of exits or raises.
Cap tables can start off relatively easy, requiring little more than a spreadsheet. For instance, if there are 2 - 5 holders with clearly agreed upon percentages, then that is as simple as it gets. You will also have help forming the company cap table by your legal team, which can assist with setting up founder’s equity as well as designating a separate pool for key employee hires later. At this stage running solo isn’t too challenging. Of course, this is somewhat dependent on the founders' prior experience and knowledge regarding implementing and administrating a cap table.
Things start getting complex once you start onboarding those new key employees and providing option grants. Part of the challenge is choosing and recording properly when unique instruments like restricted stock units (RSUs), restricted stock award (RSAs) and stock appreciation rights (SARs) come into play. Beyond that there is the changes that come with raising a round and introducing multiple share/debt classes and preferences.
Each of those choices has its own consequences that need to be baked into the decision-making process of how best to dole out equity interests in your growing company. As you can see from this starting place things become decidedly more complicated and no founder should go in alone.
Transparency: Who will be looking at a cap table, and what are they looking for?
The basic viewers of a cap table will be made up of the founders, the legal team, and of course the CFO should have full access, sometimes primary investors as well. Additionally, employees with options or equity stakes should have access to their specific interest in the company cap table. Part of offering or awarding equity to employees, investors or potential acquirers is being able to illustrate its real-time value. This concern is of interest to those interested parties both as a standalone value, as well as in relation to the total picture.
For investors, they want to understand their potential upside. It is desirable to see who has control and how much, and forecast what they will see for potential payouts under specific scenarios, potential dilution, etc. These factors provide substance to potential stakeholders. The cap table also provides insight into historical valuations and will play a role in negotiating current valuation for new funding raises. From an investor’s perspective; the cap table is a point of reference for the existing cap structure and how they might fit into that.
Employees being hired for major roles who might earn significant equity also want to ensure things are done properly and in compliance, essentially that they aren't joining or partnering with a contingent liability. Many startups offer equity to make their compensation package competitive with more established companies, supporting transparency around its valuation helps reify employee commitment and understanding of what they are getting.
A clean cap table can also make or break an audit, which could have a plethora of potential consequences depending on the reason for the audit. There is no better defense against the possibility of being audited in the first place like having well organized and maintained records to back up any questions or inquiries.
Lastly from an existing shareholder's perspective having it laid out well allows easy determination of what percentage of the company to give to the new investors in exchange for the capital contributed. Knowing the full scope of what you have is essential to getting what it is worth.
There are challenges for those who continue along the self-managed route beyond a certain point. It is common for founders who do exactly that to go into fundraising negotiations with an inaccurate idea of valuation. Those that do frequently wind up giving up too much equity, impacting themselves and/or existing investors negatively. No one wants to build up a business and then find themselves being diluted needlessly.
Other pitfalls possible are unintended tax consequences, whether for the firm or for employees granted options. Missing or inaccurately tracking option grants for employees can create both personnel and legal issues resulting in lawsuits.
There is also the damage of creating a structure that is unattractive to potential investors or upsetting to existing investors. This can lead to losing a fundraising deal or a potential acquisition not passing due-diligence.
The Advantage of Software Solutions
A simple and easy way to reap the benefits of having a subject matter expect without utilizing the full-service option of a legal team would be to pair the software solution with guidance from an outsourced CFO. EGFS provides CFOs routinely to create maximum independent control while providing dedicated and focused oversight.
By balancing self-management with experienced direction through a scenario like this you can realize great cost savings while having a strong well maintained financial structure in place to attract investors. This strategy allows for all the pros and none of the cons mentioned above.
The CFOs of EGFS utilize comprehensive cap table management for their clients which allows for robust reporting, transparency and on the spot summarizations. The cap table management systems can model the impact of various fundraising possibilities to allow for strategic and well thought out acceptance.
With the oversight and guidance of our outsourced professionals any concerns around audits are heavily mitigated. By choosing a software monitoring approach over completely outsourcing to your legal team expensive legal bills are avoided, as well as the response rate is greatly increased and on your own time table.
To find out more contact us for a consultation. Discover how we can support you and your growing company.