In the early days of your startup, ownership is pretty easy to determine. For two co-founders, ownership can be as simple as, “I own 50%, you own 50%”. Even if you raise funding from friends and family, tracking ownership can usually be done in a spreadsheet. It can look something like this:
|Jacki, from college||5%|
In financial terms, this is what’s called a capitalization table, or cap table for short. So, what is cap table? Your very first cap table could very well just include a table listing the owners of the company, and their respective percentage stakes in the company.
By the time you start issuing options and/or get into later funding rounds, however, things get very complex very quickly. Before you know it you are having to track equity dilution, model exit scenarios, monitor compliance issues, and put together a waterfall analysis.
Wait. You mean you don’t know how to do all of that already, all while building a company from the ground up? We see a lot of founders get caught in the cap table trap: “It was easy to keep up with this when I first started,” we hear. “It can’t be THAT complicated after a round of funding.”
The cap table is critical from both sides of the table. Future investors will want to see what they are buying into beforehand, and you will want to know the current equity position for you and your employees. There are horror stories out there of entrepreneurs walking away with nothing or with debt despite what appears to be a lucrative exit scenario.
In short, there are several important considerations that come with managing your financing with the cap table.
Caring is Sharing
Building a successful company means bringing in successful people to help you grow. Offering a stake in the business can help bring those people to (and keep them at) the table. That goes for investors as well as employees. Many early-stage founders get hung up trying to hold on to a certain portion of the company; it’s important to keep the big picture in mind. Would you be willing to give up half of your equity for an opportunity to grow the business 5x? Your mileage may vary, of course, but try to always be thinking several steps ahead when it comes to the growth of your startup.
Keep up with Record Keeping
Handshake deals aren’t going to cut it when it comes to equity in a business. Make sure every single transaction is documented in your cap table and a corresponding agreement. Do you want an investment raising round delayed, a large legal bill, or irritated employees as a result of an incorrect cap table?
Each transaction needs to be specifically and accurately documented. That means new issuances. Secondary transactions. Interest or dividend accruals. Option grants. Even your board minutes. Anything that is sent to your shareholders needs to be documented, and all involved parties need to agree on the same set of information at all times.
Ownership Percentage: I Don’t Think it Means What You Think it Means
For you business school grads, terms like “preferred stock”, “liquidation preferences” and “participation rights” may already be familiar to you. As more investment rounds pass, investors can and will ask for certain concessions in exchange for their money. The preferred stock allows the holding investor a benefit over common stockholders such as you and your employees. This really comes into play when talking equity. Once the preferred stock is in the game, your ownership percentage doesn’t necessarily equal the percentage cash you will get out of an exit. All of your cap table calculations will need to account for all preferred stock, including preferences, in order to keep the data correct.
Don’t Forget the Tax Man
You made it this far into the article, and we didn’t mention taxes one time! It was just too good to be true. Each and every move you make with your capitalization table has potential tax implications. Of course, it does. The good news is that with proper management, you can optimize for a favorable tax situation. The bad news is that mistakes or missing transactions in your cap table can really cost you when it comes time to clean up the mess or satisfy due-diligence. There is a lot to keep up with: 409a valuations, incentive stock option (ISO) regulations, 83(b) elections and much, much more.
Managing Your Cap Table
So that all sounds…complicated. Time-consuming. And here you are, with nothing but your wits and a spreadsheet.
There are plenty of moving pieces here and having an accounting pro who understands all the angles is crucial for startups growth. With the right solution in place, you can easily:
- Model out different exit scenarios
- Run a waterfall analysis for investors
- Address compliance needs
- Provide accurate and up to date equity data for any shareholder at any time
An improperly managed cap table can pose a significant risk for your company. EGFS can help ensure your cap table is an asset rather than a liability. Contact us today to learn how.