You’re about to raise funding for your company by bringing on advisers and investors and receiving their advice/investment in exchange for equity. If you haven’t already, you’ll soon learn what cap tables are and impact they will have on your future investment rounds and liquidity events (an acquisition or an IPO). Here is an overview of what cap tables are, why they exist, and the ways to manage them.
Before you pitch your company to potential investors, you usually will have done a pre-money valuation. This essentially provides a way for investors to, “determine how much equity to demand in return for their cash injection.”
As soon as your company has more than one investor (the first being you, of course), it is time to create a cap table to “list who owns what in a startup. [The cap table] lists the company’s shareholders and their shares.” [http://venturehacks.com/articles/cap-table]
There are a number of possible pitfalls along the way, however, mostly arising from the fact that you’re determining how shares will be distributed well into the future. Keep in mind, “Founders should expect their percent owned to decrease over time, but the number of shares will not change, and the value of these shares (measured in price per share) should increase as the company increases in value.”
In response to this question on Quora asking what his greatest lessons learned are, Max Levchin suggests that, “Having a large and complicated cap table is rarely a good idea. Few committed angels is better than $5k from everyone and their brother.”
Babak Nivi of Venture Hacks agrees with Levchin’s observation in his discussion of the “Option Pool Shuffle”. In short, beyond allocating shares to the company’s founders, employees, and investors, “the so-called pre-money valuation always includes a large unallocated option pool for new employees…” Nivi’s point is an important one: “Don’t let your investors determine the size of the option pool for you. Use a hiring plan to justify a small option pool, increase your share price, and increase your effective valution.”
Your cap table should also provide an overview of how different phases of investment and dilution will occur. A investment broken into component phases might look something like this,
1. Start Phase: Stock splits occur and dividends in kind are paid at the start of each round.
2. New Sales Phase: Sell new securities (convertible notes, preferred stock, common stock warrants, options )
3. Post Sales Phase: Record investments and share units after sale of new securities.
4. Conversion Phase: Stakeholders can convert notes and preferred shares and can exercise warrants and options to obtain common stock.
5. End Phase: Record security holdings, prices and values at the end of the investment round
The resources referenced in this post should give you a good basic understanding of why cap tables exist and what influence they have over the beginning, middle, and later stages of a company’s financial profile. When you are ready to create and manage your cap table, see our second post in this series here.