Managing equity can feel a little overwhelming as a founder. Small mistakes on the cap table may have huge financial implications for founders, employees and investors. A capitalization table (cap table) can help. But what exactly is a cap table, and why is it so important?
This guide covers what it is, the importance of keeping an accurate cap table throughout a company’s lifecycle, and the potential consequences of an outdated or neglected cap table. We recommend working with your finance team and legal counsel to make sure your cap table is accurate. If you’re looking for legal counsel, feel free to reach out to us here.
Why Cap Tables Matter
A cap table is a document that provides a breakdown of equity ownership among a company’s stakeholders, including founders, executives, employees and investors. It specifies the type of equity held by each stakeholder and is primarily used to offer a precise view of the company’s current ownership.
Cap tables are important for startups for several reasons:
- Ownership Tracking. A cap table provides a clear snapshot of who owns what in a company. It helps founders track equity distribution among stakeholders such as founders, employees and investors.
- Investor Attraction. Potential investors often request to see a cap table to understand the company’s equity distribution and their potential stake. An accurate and up-to-date cap table can demonstrate that a company is well-organized, attracting more investors.
- Strategic Decision Making. A cap table can serve as an important tool for strategic planning. By providing a comprehensive view of the company’s equity structure, it helps founders make informed decisions regarding future financing rounds, equity grants, business valuations or even exit strategies.
- Legal Compliance. Companies are legally required to maintain records of their securities issuances. A cap table ensures this by keeping track of all transactions, thus helping a company comply with securities laws and regulations.
- Equity-Based Compensation. For companies that offer equity as part of their compensation package, a cap table is necessary to monitor the distribution and vesting of stock options or shares.
Keeping an accurate cap table throughout your company’s lifecycle is crucial for avoiding legal disputes, making informed decisions about fundraising and corporate events, and understanding who owns what percentage of your business. A neglected or outdated cap table can cause misunderstandings over equity packages and can create serious issues at funding. By investing time and effort in accurately setting it up initially, you can save yourself significant complications down the line.
Reading a Cap Table
Reading a cap table, usually a spreadsheet for a private company, involves understanding specific core components:
- Shareholder’s Name. Listed exactly as it appears on the stock certificate or other security instrument.
- Type of Equity. The kind of equity each shareholder owns, such as common shares, Series A preferred stock, employee stock options, warrants, etc.
- Equity Amount. The quantity of equity owned by each shareholder, usually measured in number of shares or units.
- Equity Issue Date. The date when the equity was granted or issued.
- Fully Diluted Shares. The percentage of ownership in the company on a fully diluted basis.
These essentials should be organized for easy reading. A comprehensive cap table may include more details, but these basics provide the necessary understanding.
Types of Securities on the Cap Table
Equity can take various forms, especially after multiple funding rounds. Here’s a simplified guide to common equity types typically seen in cap tables:
- Common Stock. The simplest form of equity is often granted to founders and employees. Owning a share of common stock means owning the most basic version of a share of the company. To learn more about common stock, click here.
- Preferred Stock. Preferred stock is a type of equity security that offers certain benefits or preferences over common stock. For example, preferred stockholders may be entitled to receive dividends before common stockholders, have the right to vote on certain matters and the ability to appoint board members. They may also be the first to receive a payout upon acquisition. To learn more about preferred stock, click here.
- Employee Stock Options. These are a form of equity that allows the holder to buy a number of common stock shares at a fixed price at some point in the future. Stock options are a common form of equity-based employee compensation. To learn more about stock options, click here.
- Restricted Stock Awards (RSAs). RSAs are company common stock, which are usually tied to a vesting period and may contain other restrictions. To learn more about RSAs, click here.
- Restricted Stock Units (RSUs). RSUs convert into common stock when conditions such as time restrictions and a liquidity event are met. To learn more about RSUs, click here.
- Warrants. Similar to stock options, warrants give the owner the right (but not the obligation) to buy a number of stock shares at a fixed price in the future. While not common for employees, they are often issued to investors. To learn more about warrants, click here.
- Convertible Notes. A convertible note, also called convertible debt, is a loan (debt) from an investor which, under certain circumstances, may be converted into preferred stock in the company (equity). They are a common security for early-stage funding. To learn more about convertible notes, click here.
- SAFEs. A Simple Agreement for Future Equity (SAFE) is a contractual convertible financing agreement between a startup and its investors (SAFE investor) in which the investment converts to equity when the startup raises a future round of funding. To learn more about SAFEs, click here.
This list isn’t exhaustive but serves as a foundation for understanding different equity types in a cap table.
Pro Forma Cap Table
A cap table shows the current state of the company’s equity allocation, but what if you want to understand what the ownership structure (and dilution) would look like after raising another round of funding? That’s where a pro forma cap table can help.
A pro forma cap table is a forward-looking tool used by companies, especially startups, to plan for future fundraising rounds or business events such as mergers or acquisitions. It’s a hypothetical cap table that outlines what the company’s equity structure might look like after a future event or transaction occurs.
This includes equity dilution due to the issuance of new shares, the exercise of options, conversion of convertible notes or SAFEs into equity, or other changes in the company’s capital structure. By providing a projection of the company’s ownership structure post-transaction, a pro forma cap table helps stakeholders understand their potential dilution and valuation impact, thereby assisting in decision-making.
In conclusion, a cap table is a crucial document for any startup. It helps track equity ownership, attract investors, make informed decisions and comply with legal regulations. Understanding the different types of equity in a cap table is also critical for founders and stakeholders. Keeping an accurate cap table throughout a company’s lifecycle is crucial for avoiding legal disputes, making informed decisions about fundraising and corporate events, and understanding who owns what percentage of the business. By investing time and effort in accurately setting it up initially, startups can save themselves significant complications down the line.