Cap Tables 101 (Why didn’t we think of this sooner?!)

A few weeks ago, Eden prompted a casual Facebook conversation about a cap table he reviewed that was beyond repair. Our community expressed a strong interest to learn more, so we responded by hosting a Casual Aleph presentation and discussion on the topic.

It turns out that cap table dynamics is not a “casual” issue. The tone and level of discussion on the Facebook post was merely the precursor. When we launched sign-up for the event, we were blown away by overwhelming response (registration was filled within 3 hours) and the community’s engagement.

We closed attendance at one hundred people and, unfortunately, were unable to accommodate and respond to everyone. In response to requests at the event and on Facebook, we thought it would be useful to publish a framework of the basic terms in cap tables and investment agreements.

This document is a live discussion and we will add terms and descriptions based on your continued feedback. In a series of later posts, we plan to focus on the mechanics of cap tables and the “problems and solutions” discussed at the Aleph event.

The most important thing to internalize is that every line on your cap table should add value to your company. It should make your company more attractive to employees, investors and partners.

What is a Capitalization Table (aka Cap Table)? — It’s a spreadsheet that contains the details of the ownership stakes in a company. The purpose is to record and simulate ownership scenarios given various stakeholders who might hold different types of securities, each with different terms. While the cap table may seem like a simple, technical document, it is a foundational component in the growth and evolution of a successful company. Knowing and managing your cap table is critical to help you determine, negotiate and track ownership stakes as the company grows. A company’s cap table is updated after changes are made to the number of shares outstanding or when shares change ownership.

The following events will cause a change to a company’s cap table:

• Selling new shares of an existing security or issuing shares of a new security.
• Increasing the size of the Option Pool.
• Granting options to an employee or advisor.
• Terminating options when an employee leaves the Company or when the options expire unexercised.
• An investor exercising vested options.
• An investor redeeming shares back to the company or transferring or selling shares to someone else.

Common Shares — The shares that have the most basic set of rights, privileges and preferences. Generally, founders, employees and some angel investors hold common shares.

Preferred Shares — A security that represents an equity ownership position in a company and contains a series of additional rights over common shares. The preference defines the waterfall of returns once the company goes through a liquidation event. In other words, the rights contained in the preferred share govern economics and control rights, and are designed to protect an investor. The rights that preferred shareholders get should serve to align the interests of investors and founders.

Participating-Preferred vs. Non-Participating Preferred Shares — In case of a liquidation event, participating-preferred shares first get their full investment (oftentimes plus interest) and then their pro-rata share of ownership, together with the other shareholders. Non-participating preferred shares, on the other hand, give the holder the right to collect the higher of (i) the amount invested in the company (sometimes this amount receives an annual interest) or (ii) a pro-rata share in the liquidation amount.

For example, an investor makes a $10-million investment in a Series C preferred share that is participating-preferred at a pre-money valuation of $40-million for a 20% stake in the company ($10-million / $50-million post-money valuation). Later, the company is sold for $110-million. The Series C investor will get the first $10-million and then they’ll get 20% of the remaining $100-million ($20-million) for a total of $30-million. In this example, if the Series C preferred share was non-participating preferred, the Series C investors would have the right to choose to receive the higher of the first $10-million or 20% of $110-million or $22-million.

In our discussion at the event, we argued that using the mechanism of participating-preferred shares was counter-productive in early-stage financings and creates dis-alignment in the cap table. It also has serious implications on the ability of the company to raise money in later rounds due to the stacking of preference and the crushing of the stakes of entrepreneurs.

ESOP (Employee Share Ownership Plan) — An employee-owner method that provides a company’s workforce with an ownership interest in the company. Using ESOP, companies provide their employees a right (“an option”) to purchase the company’s shares at a fixed price. ESOP shares are part of employees’ remuneration for work performed and are therefore subject to tax (we will explain about the Israeli 102 law that provides for a lower, 25% tax for employee options). Shares are allocated to employees and may be held in an ESOP trust until the employee leaves or until an exit event. From a cap table perspective, we distinguish between the allocated and unallocated ESOP shares. In a high growth startup, your ESOP is a key factor in attracting talent. Employee options generally convert into common stock. So if you pile on too much preference in the form of participating preferred, you add a level of difficulty in recruiting great talent to your startup. If you do not allocate sufficient ESOP, you will also find yourself challenged to recruit top notch talent which is usually motivated by the upside of stock.

Anti-dilution — A provision that protects an investor from dilution resulting from later issues of shares at a lower price than the investor originally paid.

Full Ratchet Anti Dilution — A case in which a protected investor is given the benefit of a lower price in subsequent rounds, if the company is willing to sell it’s shares for a price lower than the price the investor paid. For example, an investor who paid $2 per share for a 10% stake would get more shares in order to maintain that stake if a subsequent round of financing were to come through at $1 per share. The early round investor would have the right to convert her shares at the $1 price, thereby doubling the number of shares. When this provision is provided to an investor early on, it may result in disproportionate holdings in the hand of a single investor if the company is unable to raise money at higher valuations. Most of the cap tables we have seen with a full ratchet can be awfully painful for entrepreneurs if the company hits a rough patch (and most companies hit a rough patch).

Weighted Average Anti Dilution — Weighted average anti dilution is an industry standard. According to this mechanism, the initial investor’s protection is based on a formula which takes into account (1) the relative difference between the number of shares issued to the new investor at the new lower price, versus how many shares would have been issued to the new investor if he had paid the first investor’s higher price, and (2) the
extent of the dilution caused by the new investment.

Your company’s cap table is the outcome of your negotiation effort to bring new investors into your company. Each line represents a class of shareholders that have rights in the company, and, hopefully, bring value as well. It’s important to keep a tab on the various rights and potential conflicts between each class of shares and always think one step ahead about what will be the potential outcome of the next round.

This post is the first in a series and just an introduction to basic cap tables terminology. In the next post, we’ll share some sample cap tables as well as the questions (and answers) raised by the audience. Feel free to comment and suggest topics for this series.

Thanks to Hilly Rejwan for her contribution in collecting information for the post and to Michael Eisenberg and Eden Shochat for reading, commenting and editing earlier versions. And thanks to Ami Hordes and others who commented on the post and helped improve it.