Navigating the Cap Table
I realize that there are a number of resources out there that describe cap tables, dilution math, waterfalls, and investments securities. Yet, I still find that investors and entrepreneurs alike continue to be either confused or ignorant regarding these concepts. In this post, I walk through the Cliff Note’s version of these concepts with the goal of increasing knowledge and familiarity. This post is not a substitute for sound legal counsel when raising funds for or investing in an early stage company.
What is a Cap Table?
A “Cap Table”, short for capitalization table, is a visual representation of the ownership of a company. The cap table will often be created by a company’s CFO, CEO, or in some cases legal counsel. The cap table is useful for two purposes 1) as a record of the ownership of a company and 2) to be used in projecting how company ownership structure will change over time. A rudimentary cap table is shown in Figure 1 below.
Cap tables are applicable for larger public companies, but are generally not produced (but ownership structure is closely tracked). For many public companies, shares are regularly traded openly on an exchange, thus ownership can change quite rapidly.
For private companies, particularly startups, the ownership structure stays relatively static over longer time intervals. Nonetheless, startups often undergo multiple equity financings (Seed, Series A, Series B, Series C, etc.) in which new equity securities are issued. Additionally, startups often award equity to employees as incentive and retention mechanisms. These awards generally occur when an employee starts and then again on an annual or semi-annual basis.
A founder of a company is keenly interested in the changes to the cap table that occur because of a new financing. The founder may have gone without cash compensation for a considerable period and subjected themselves to a high level of risk during the company’s formation. The founder of the company is generally interested in maintaining the largest ownership of the company possible (However, there is a saying that “Small ownership in something huge is worth a lot more than substantial ownership in something worth nothing”).
In Figure 1, the two founders of the company have given up 40% ownership in their company: 10% to an angel investor who likely put money in a seed round, 20% to a venture capital investor, and 10% of the company’s shares have been reserved for distribution to employees as options.
As subsequent financing events occur, each new set of securities issued (often referred to as a Class or Series) may have separate sets of economic and control rights (to be discussed later). Further, a venture investor may purchase multiple classes of shares (investing in both the Series A and Series B of a company). Figure 2 below shows a cap table with multiple classes of stock.
Keeping track of these rights and their impacts on shareholder voting and cash distributions can be quite complicated. The cap table is the appropriate tool for managing all classes of shares.
It’s worth noting that having an overly complicated or “messy” capitalization structure is often cited as a reason that VCs pass on making an investment in a company. Within the VC community, there is a bias towards keeping the capitalization structure of a company “simple”. Having an organized cap table can help convey this simplicity in your company.
Shareholder Ledger
The cap table is closely related to the shareholder ledger and indeed the shareholder ledger could feed into the cap table as an input. A shareholder ledger lists detailed information about historical stock purchases, stock forfeitures and exchanges, and existing stockholders. An example shareholder ledger is shown in Figure 3 below.
Startup Securities
This is section is not meant to be an exhaustive review of the securities used in startup financing events, but will provide information to the extent necessary for understanding cap tables. For a more thorough reference, please review Ventures Deals by Brad Feld and Jason Mendelson.
The two most common securities used to raise capital for startups are convertible debt and preferred stock.
Convertible Debt
Convertible debt is most often used in two situations: 1) when a company is early stage and wants to avoid pricing (such as in a seed round) and 2) when the company is getting low in cash, but hasn’t reached an appropriate milestone to raise a new round, get acquired, or go public. The existing investors may “bridge” the company in this scenario to provide enough cash to get to the next company milestone.
Additionally, convertible notes can involve less legal complexity (thus lower legal cost) and can be quicker to execute.
There are several different flavors of convertible notes, but generally the major economic terms are:
- The notes will bear an interest rate, 6–8% simple annual interest is common.
- The notes will have maturity date when principal and accumulated interest will be paid back, 12–24 months is common.
- The convertible note will convert into equity at some prescribed event (such as an equity financing).
When the notes convert into equity they will often do so at some discount, 20% is common. The conversion mechanics are displayed in Figure 4 below.
In Figure 4, the investor lent $250,000 to the company in the form of a convertible note with 8% simple interest and a discount to the next round of 20%. The note converted into equity shares at the closing of the company’s Series A financing nine months later.
As mentioned previously, there are other flavors of convertible notes with various other conversion mechanics. For more on this, check out this write up at AskTheVC.
Preferred Stock
When I buy a share of a stock exchange listed stock, this is generally in the form of common stock. Preferred stock has many similarities with common stock except preferred stock may have several investor friendly attributes. These attributes define privileges that preferred stock holders may have with regards to economics and control. There are many variations of preferred stock, but the section below outlines the most relevant items when thinking about cap tables.
Share Price: the issue price of the preferred shares
Dividends: Dividends are payments made to the shareholders from available cash, or promised to shareholders when there is not available cash. In venture capital transactions, dividend rates are generally between 6–8% of the share price. Preferred investors will usually receive dividends before (in preference to) common investors. There are two types of preferred dividends: cumulative and non-cumulative. Cumulative dividends accrue without receiving additional board or shareholder approval. Usually, they are paid at a liquidity event. Cumulative dividends can have large consequences on the liquidation preference (see below). Non-cumulative dividends do not accrue and only become payable when and if declared by the board. It is rare for a startup to pay dividends.
Liquidation Preference: The liquidation preference describes how cash gets divided up between the preferred shareholders and the common shareholders during a liquidation event (usually acquisition). The preferred investors want to get paid (or have the option to get paid) prior to the common shareholders. There are two flavors of liquidation preference: non-participating and participating.
At a liquidity event, investors who have non-participating preferred shares have the option to receive some multiple of their investment (plus any declared but unpaid dividends) or to convert their preferred shares to common shares, thus participating proportionally in cash distributions. It is typical for the multiple to be 1x, but multiples higher than 1x are not unheard of. Profit maximizing investors will choose the option that gets them the most cash.
Investors with participating preferred shares received a multiple of their investment prior to common shareholders (usually the multiple is 1x). After receiving this payment, the participating preferred shares participate proportionally with the common shares in further distributions.
In summary, non-participating shares get either a multiple of the investment or convert to common to get the pro-rata distribution. Participating preferred shares, however, receive the multiple of the investment and get the benefit of receiving distributions along with common shares.
Any accumulated dividends (cumulative dividends or declared but unpaid non-cumulative dividends) are added to the liquidation preference during a liquidation event.
Control Privileges: Preferred investors will also receive special control privileges. An example of such privilege might be that the company must receive permission from the preferred investors to sell the company. Often, unanimous approval will not be required, but a certain percentage (such as 60% by number of preferred shares) will be required. Each preferred share usually has one vote, thus tracking the percentage ownership by ownership class can be an important task when determining voting outcomes. Preferred investors may also have right to a seat on the company’s board of directors. Additional examples of control privileges can be seen in the National Venture Capital Association model term sheet.
Share Price and Valuation
There are various terms used to describe the company’s valuation during an equity financing. These are: share price, pre-money valuation, and post-money valuation. These terms can be confusing as they are interchangeable to a degree.
Share Price: Share price reflects the price an investor paid or is offering to pay for a share of the company’s stock. It’s important to note that investors are usually purchasing newly created shares directly from the company. In the public markets, stock buyers are usually buying existing shares from an existing shareholder.
Pre-Money Valuation: The pre-money valuation or “pre-money” (or simply “the pre”) describes the company’s value prior to a new round of financing. Pre-money represents how much an investor values the company and therefore how much the investor is willing to pay to purchase a percentage of the company. It could also be thought of the company’s market cap prior to issuing new shares for the new financing. When an investor specifies a pre-money valuation, they are directly describing the share price they are willing to pay. Pre-money is related to share price in the following manner:
Pre-money valuation is often used as point of negotiation (e.g. “We really think we are worth a $20 M pre-money valuation”) and for statistics tracking (“the average series A pre-money valuations for SaaS companies in 2015 was $12 M”).
Post-Money Valuation: The post money valuation reflects the market cap of the company after the completion of the new round. It is most useful for thinking about future scenarios (“If the post money value of the company is $50 M, we’ll need to exit at least $200 M to get 4x our money”). It is also useful for thinking about the change in value between rounds (“the post money of the Series A was $18 M and the pre-money of the Series B was $36 mm, a 2x step up!”). Post-money valuation can be calculated as follows:
As you can see, share price, pre-money, and post-money are all linked together. Various permutations of the above formulas can get you the following.
Post-money should be used to determine ownership derived from the new capital infusion. For example, “For $5 M, I want to own 25% of the company” implies a $20 M post- money valuation (if the total round size is also $5 M).
These equations are not strictly precise in all scenarios (such as when there is a convertible note involved). In the case where there is a convertible note outstanding, the post-money valuation can be calculated in the following manner:
Options pool and fully diluted ownership
One last element, before putting all this together, is the employee option pool. The option pool can represent a significant piece of company ownership. The option pool may not be exclusively used for employees; it can also be used to compensate board members, consultants, contractors, or service providers.
The employee option pool is usually created or refreshed at company financing events. The central point of negotiation between investors and founders regarding the option pool creation is “who pays for it”. If 10% of the company is going to be given to employees, where does that 10% come from: founders, investors, or some combination. In many venture financing events, the allocation for a new or refreshed employee option pool to come from the founders and existing investors. The verbiage in the term sheet will look something like the following:
Pre-Money Valuation: The Original Purchase Price is based upon a fully-diluted pre-money valuation of $8,000,000 (including an employee pool representing 10% of the fully diluted post-money capitalization).
Note a few things: First, the option pool is included in the pre-money valuation, meaning that this allocation is accounted for as shares that exist in the company prior to the new financing round. Using the equation in the previous section, including the new option pool in the pre-money results in the lower share price than if it is included as part of the post-money. Figure 5 below illustrates this concept.
Alternatively, the allocation for the option pool could come from both founders, existing investors, and new investors. This is referred to as coming from the post-money.
Also note that the term sheet verbiage above specifies the size of the option pool as a percent of the post-money capitalization. Thus, a bit of math must be done in order determine the number of shares to be issued for the option pool. The following equation can be used to calculate this level:
Doing a little algebra, the direct calculation can be derived:
Note these equations are not strictly accurate for options in the pre-money and may require some iterative calculation. Observant readers will note that “Preferred Stock to be purchased” is a function of share price, which is itself a function of the options issued (if included the pre-money).
In our example above, there are one million shares currently outstanding and the investors require a new option pool to be created in the pre-money shares, with the number of options authorized equal to 10% of the company’s post-money capitalization. If we assume that there are currently no options outstanding, we can calculate that 142,857 new options are to be authorized in the pre-money, resulting in a price per share that is 12.5% lower than it would have been otherwise.
Again, while authorizing new options “in the pre-money” does not affect the pre-money valuation, it does affect the pre-money shares outstanding and thus the share price. Share price with options in the pre-money can be calculated as follows:
As a final part to this section, it is worth noting that the definition of “fully diluted ownership”. A fully diluted ownership assumes that all available options have been allocated to employees (issued and outstanding). It also assumes that convertible instruments such as convertible notes or warrants convert into shares. VCs tend to deal in fully diluted ownership. In reality, the current ownership of the company is dictated by shares that are in fact issued and outstanding. For example, if we create a 10% available options pool, but the company is acquired prior to allocating any of the options, only the shares that are held by individuals or investors count towards calculating the allocation of the acquisition proceeds.
Putting It All Together
Putting all the pieces together is best illustrated by example.
We start off with the founding cap table of the company, with two founders each owning 50%.
The company then goes on to issue a convertible note to raise a $250k seed round from an Angel investor in January 2017. The note bears an 8% simple annual interest rate and will convert with a 20% discount to the share price in the next equity round.
Nine months later, the company raises a Series A investment from a VC. The VC invests in the company at an $8 M pre-money valuation and provides $2 M to the company. As part of the financing, the VC requires the company to create a pre-money option pool equal to 10% of the company’s post-money capitalization. We’ll assuming the Series A was non-participating preferred with no dividends. The convertible note also converts into Series A shares at the prescribed discount.
Note that in this case, it’s easiest to use Excel’s solver function to determine the option pool size. To do this, click on Data->What-If Analysis->Goal Seek. Then set the cell representing the fully diluted ownership of the options pool to .1 (10%) and solve for the options pool.
The company then goes on to raises a $8 M Series B investment from the existing venture investor as well as a new strategic investor. We’ll assume that the pre-money valuation was $20 M and that no additions to the option pool are made. We’ll also assume that the Series B is non-participating preferred and no dividends.
At this point, company has done really well. They receive and accept an acquisition offer for $100 M from a large corporation. Since the acquisition offer is much higher than the post money of the last round, and the securities used were non-participating, the liquidation preferences will not come into effect. All the preferred shares will convert to common shares. We’ll also assume that we have allocated the full option pool to employees such the fully diluted ownership equals the actual ownership. The calculation of the distributions at a liquidity event is known as the “waterfall”.
To calculate an investor internal rate of rate (IRR), use Excel’s xirr function on the investor cash flows with dates. This is shown in the figure below.
Wrap Up
We covered a lot of ground in this article, thanks for sticking through it.
Though there are some norms in venture capital, each financing has certain features that make them unique. Different investors have different views on their desired investment terms, and (correspondingly) entrepreneurs also have different views. It is important to work through through these different terms, their implications on the cap table, and ultimately the exit scenario. As mentioned previously, this article isn’t substitute for sound legal counsel.
In the “Putting It All Together” example, I went through a fairly straight forward preference and acquisition scenario. The cap table and acquisition waterfall can be much more complicated. Let me know if you’d like to see a future article with some different scenarios modeled out.
The spreadsheet behind the figures in this article can be found here.
Thanks to Brendan Johnson from Bryan Cave for helping with the review of this article.
