Understanding Cap Tables

There’s a lot riding on cap tables. They, in theory, tell us who owns what equity in a company.  But not all cap tables are created equal.  Some show only issued shares, but not option pools or unissued shares.  Some don’t include the soon-to-be shares in convertible notes.  Opinions vary on the correct format, so it’s important to understand what to look for.  That’s exactly what you’ll be able to do after listening to this episode of the Seedfunders podcast.

Welcome Sir.

Thanks Joe. Good to see you.

One thing you mentioned in a previous podcast that I’d love to dig into a little bit more today is the Cap Table. First, let’s just cover the basics. What’s a Cap Table?

Formally, it’s called a Capitalization Table. Obviously, Cap Table for short. The best definition I could find really this best and simplest definition is basically a spreadsheet that lists all of the ownership stakes in the company. That’s a simple definition, but obviously it gets much more complicated. We’ll get into a lot of those details. It is one of the first documents that’s created for a startup, because it’s important to list obviously, the names and the ownership of all the owners of the company; which proportions they have, and which ownership and what type of stock they hold. It’s a really important document. In fact, from an investor standpoint, it’s probably the most important document that we review in determining whether to make an investment or not.

I notice you mention a few of the things there. We’re just building a Cap Table. What info exactly is included on that table?

First, the names of the all equity holders. Of who owns equity, who owns parts of this company? The dates that they purchased that equity or granted, if it was granted to them. The number of shares or units is very important to know how many units somebody has. Then the type of equity as well. You could have common stock. There could be preferred stock. There’s options or warrants granted to some of the employees or the founders. The liquidity preference is typically on there. Is it a liquidity preference where it’s in exit only or is it participating preferred which is basically where the investor gets their investment back, and the equity? Those types of things are very important to put on a Cap Table.

Also, various rounds of investments. How much is founders’ equity that the original founders get? What about the seed stage investment? There is a pre-seed, seed stage, seed 1, seed 2. Is there Series A, Series B? That type of information needs to be on the Cap Table for a potential investor to understand the capital structure of the company. Who invested what and when? Finally, regarding options, it should include a reserve for equity to be issued in the future to employees. Typically, companies say, “In the future we’re going to hire some key people. We need to reserve some equity for those people.” This basically, all allows an investor to calculate their proposed equity on what is called a fully diluted basis. Meaning that everything that’s known is on the Cap Table.

Let’s dig into that a little more. Exactly, what is the concept fully diluted?

That’s really a good question. It really does get complicated. There really is no one definition of fully diluted. But fully diluted commonly assumes that a Cap Table includes of course, all the common stock. Plus, all the preferred stock that will be converted to common stock at some point. Plus, all outstanding options, warrants and other rights to acquire shares that have been exercised or issued to employees or others. Really, the common definition of a Cap Table includes common stock, preferred stock and warrants and options that have been issued. However, when it comes to any shares to be issued in the future, to employees or the founders or anybody else, there really is no agreement on what should be included on a Cap Table.

For example, there could be shares remaining or not yet issued in an existing plan. The plan is, “We’re going to issue 500,000 shares to employees,” but only 250,000 have been issued. The question is, is the 250,000 issued on the Cap Table or the entire 500,000, because it will be issued in the future? The same thing happens with shares that are not issued into existing plans. Like the things that I just explained about. Are they going to reserve a number of shares? A million shares reserved for future employees, should that be on the Cap Table or not? It’s basically informally reserved. So, some people say it should be on the Cap Table. Some say it shouldn’t.

I think however, all this needs to be considered. When an investor knows the real percentage of equity that they’re getting without future dilution impact. Otherwise, there could be this equity issued in the future that the investor gets diluted that should have been known about. I think all that needs to be involved on the Cap Table.

What immediately jumps to my mind is convertible notes. They’re not converted yet, but they likely will be. Should they be included on the Cap Table?

That is really one of the biggest controversies on Cap Tables and investors. Really, I think certainly they do need to be considered, and here is why. That money has already been invested in the company and spent. So, say it’s $1 million. There’s $1 million in convertible notes. The money has been spent. It’s been funded. Spent by the company. We come along. And we invest $150,000. SeedFunders invests $150,000 in a company that has $1 million in convertible notes. That $150,000 would typically be not enough to require the convertible notes to convert. So, we have $150,000 in equity. But then in the future, there is another investment round, and it does trigger the conversion of the convertible note.

All of a sudden, $1 million gets converted to equity. We’ve just been deluded as though that’s new funding to help the company grow even though it was spent in the past. We have a huge delusion there as a previous investor on something that existed when we invested, but wasn’t capitalized or wasn’t converted until a future event. The problem is how do you account for the equity. Since, we don’t know the conversion price, because on the convertible note it could be a discount, it could be a Cap, it could be more than the Cap. So, we don’t know what the convertible note is going to be converted at. A lot of founders just leave that off the Cap Table and say, “We don’t know. We’re just not going to put it on there,” but you can always assume something. Maybe you assume the Cap on the note or something like that.

This all comes from personal experience and deals have fallen through. I’ll give one quick example. We’re going to invest in a company at valuation was $3 million I believe. We agreed on it. Then we found out in due diligence there was $1 million in convertible notes. So, we said, “That needs to be included so we know the fully diluted value of our investment.” The attorney on the other side said, “Absolutely not. That’s going to be converted in the future. It’s not part of the current valuation.” Our position was, “Of course, it’s part of the current valuation. It was already invested and spent.” Our conclusion really was that they were asking for a four million-dollar valuation. The $3 million that we were willing to invest at. Plus $1 million that was not even part of the deal that we were involved with. That deal definitely fell through, because we did not think it was reasonable to not include the convertible notes in the valuation at the time.

Wow, [7:01]. What about some other problems you may have seen with Cap Tables in your travels?

Mostly, problems regarding accuracy. The Cap Table’s not been updated or accurate. I’m guilty of that myself with my first exit. My first venture capital funding, the venture capitalist came into the room and said, “We want to see your documents, doing their due diligence.” And looked at the Cap Table and it was a mess. I admit. It was a mess. I didn’t know the difference to what was important. We had employees who got stock grants and other employees who got grants and then sold that equity to other employees or to friends and family. The VC was looking at the books thinking, “Is this new equity that’s listed here? Is this somebody bought this equity?” It took days to figure out what should have been really is if I had maintained a reasonable Cap Table. It’s really important. It needs to be accurate. There’s employees that could have shares. There’s not correctly documented. There could be new shares. There’s a lot of things that could really kill a deal if the Cap Table is not accurate.

Once the attorneys and the VCs start to look at the details, it could really be telling. It really shows the importance of keeping accurate records and keeping the Cap Table current. The other thing I’ve seen, multiple versions of a Cap Table. We do due diligence and the legal documents show one Cap Table, but the CPA has a different Cap Table. Maybe the founder has a different Cap Table, because it wasn’t all in one document. It was not updated correctly, some were or some weren’t. There’s huge problems sometimes with Cap Tables. And they could really – as I said – kill the deal. The other thing that we’ve seen. That again I alluded to before is, not recording what we call non-dilutive shares.

Here is an example. Say a consultant worked for the startup. Has an agreement to get 5% equity in the company – non-dilutive. What that means is it’s always going to be 5%. You can’t determine how many shares that consultant is going to get. If it’s 100,000, 5% obviously is 5000 shares. But if the company issues 500,000 new shares, the consultant then gets 5% of that. So, an additional 50,000. It really gets confusing, because these shares are not issued until liquidation. A lot of founders say, “That shouldn’t be on the Cap Table, because we haven’t issued those shares.” That’s a huge problem for investors to come in and then find out there’s going to be a 5% dilution on the future liquidation, because that agreement was signed, even though it was not on the Cap Table. Again, those are really serious issues with Cap Tables that we have seen.

Just a note, my Seiko calculator watch tells me that 5% of 500,000 in shares is 25,000. Given how complicated all this is and consuming for the startup – time consuming and so many different options. What do you recommend that startup founders do to minimize some of these problems?

There are software programs out there that can be used. I’m not an influencer. I don’t get any compensation for any recommendations, but the most common one that I’ve seen is called Carta. They have about 20,000 users. We’ve seen when we’re making investments that we get a Carta log in that we put in to see the Cap Table in Carta for our investments. You can go on and find a lot. There’s Astrella, GEMS^pm, EquityEffect and others. There are a number of software systems that can be used to help minimize the errors. As a Cap Table gets complicated, it’s a good idea to automate that with the software management. Then it could really help out the founders.

You may not get paid Dave, but you’re definitely an influencer. I think the robe and the staff you carry around helps too. It may just be me. Let’s look at Waterfall Analysis. I’ve heard that term a lot. Especially when talking about liquidity events for startup. How does a Cap Table play a part in the Waterfall analysis?

A Waterfall analysis shows the amount that every equity holder would receive in the event of a liquidity event or exit. It’s basically, the Cap Table. How much is everybody going to get? The Cap Table obviously plays an important part of that. Say, a company sells for $10 million. The Cap Table will then be used to determine who gets the first payouts. Say it’s participating preferred equity holders. They would get the money out first. Then they would convert to common shares, which will then be shares at a percentage of the other common shareholders. There’s other metrics that would be included in that. The Cap Table becomes the document that determines the Waterfall Analysis. It determines who gets how much when there is an exit. Basically, the Cap Table has all the data to determine that and how to divide up the proceeds on the sale of the company or when there’s an exit.

Anything else that a Cap Table can be used for?

One thing I would point out would be to modelling or simulation. For example, if a founder is considering accepting an investment of say $500,000 for 500,000 shares, the Cap Table can be used to determine what impact that would have on his or her ownership percentage. They put those numbers into the Cap Table, recalculate if we take in $500,000, if we issue 500,000 in shares and whether it’s common or preferred, how does that affect the existing equity holders that are on the Cap Table? They would just add those shares to the existing ones and recalculate the ownership percent for all of the equity holders. Similarly, they could calculate the impact of bringing in key employees or granting 100,000 shares to somebody. How does that impact the founders or all the equity holders? The Cap Table, if it’s correctly formulated, it can make those tasks pretty simple to simulate or look at what would be the impact in modelling for those new shares that would be issued.

Great information. How about a Waterfall Analysis for this episode?

Obviously, the Cap Table is very important, but it needs to be maintained and accurate. Poor Cap Tables can kill investments. And have killed investments. It can be difficult for investors to analyze. As always, I’ve got to point one thing out. Angel groups have experience. We know what to look for in Cap Tables. We know what they [13:02] missing. It’s much better to be part – and I’ve said this before – to be of an angel group than to try to go it alone, because Cap Tables can be complicated. If you don’t really know what to look for, the angel groups can definitely help. Being a member of an angel group.