Cap Table 101

If an idea was good enough, and the team strong enough that they didn’t require a pitch deck or a product demo, VCs would still require this one document — a Capitalisation Table (often shortened to Cap Table) — before deciding to invest.

Put simply, a cap table is a register of a company’s shareholders and how much they own. Unfortunately, as a company matures, the cap table develops into a much more complicated beast. But don’t sweat, we will try our best to explain it all in this article.

Other than recording ownership information, the cap table enables investors and founders to calculate their ownership value in various business scenarios, thereby assisting them in negotiations around changes to ownership stake should those events unfold.

Starting from the very beginning, a pre-seed start-up with two equally capable and committed co-founders would likely have both co-founders each owning 50% of the start-up’s shares, so nobody develops a swelling inferiority complex overtime.

Figure 1. Pre-seed investment example Cap Table

Over time, start-up equity usually falls into the following three pools:

1. Common Shares Pool (for founders, employees, angels, and advisors)
2. Preference Shares Pool (for investors)
3. Options Shares Pool (for directors, advisors, and employees)

There is no single answer for how to split equity in the founders’ pool, but a popular option postulated by Professor L. Frank Demmler is the ‘Founder’s Pie Calculator’ — a framework that determines founder equity based on the following dimensions:

a. Idea generation;
b. Business Plan Preparation;
c. Domain Expertise;
d. Commitment and Risk;
e. Responsibilities.

But more on this in a separate article.

1. KEY CONCEPTS

Before we dive into what a later stage cap table looks like, here are 5 key concepts to understand:

1.1 Common vs Preferred Shares

Common shares — impart the most basic rights, privileges and preferences to those that hold them, including the rights to disclose company performance or to exercise a degree of control over operations. Typically held by founders, employees and angels.

Preferred shares — impart additional rights on top of those provided by common shares, generally giving priority to security holder for company returns in a liquidation event.

Figure 2. Ownership by stage (Source: Capshare)

1.2 Participating Preferred vs Non-Participating preferred

Participating preferred shares — receives their full investment amount AND pro-rata share of remaining ownership in a liquidation event.

Non-participating preferred shares — receives their full investment amount OR a pro-rata share in the liquidation amount.

Figure 3. Participating Returns vs Non Participating Returns

1.3 Convertible Notes

Convertible Notes (a.k.a. convertible bonds) — are debt agreements with the option to purchase equity at a discount in the following round. These are generally seen in seed/ series A rounds where there is a larger risk of the start-up not succeeding. A typical conversion carries an interest rate ~10% and discount for the next round of ~20%.

1.4 ESOP

Employee Stock Ownership Plan (ESOP) — provides employees with an ownership stake to align their interests with the company. ESOP gives employees a right to purchase shares in a company at a fixed price, and is generally distributed as part of an employee’s remuneration package. As an incentive mechanism, ESOP is a powerful tool to use early on in a company’s life time, especially when they have limited cash flow.

1.5 Dilution

Fully diluted % equity — Often in later stage cap tables, a fully diluted % equity column exists to illustrate the ownership structure should all convertible notes and options on the cap table have been exercised. On raises, founders are usually first to give up their equity for capital, hence diluting their stake in their start-up.

Anti-dilution — a standard provision in investor shareholder agreements that prevent their stake from being diluted after new shares have been issued. Also considered a pre-emptive / protective/ pro-rata measure.

Full ratchet dilution — In a case where an investor with the protection of this clause has paid a higher price per share in a previous round (say $10/share at 20% stake), the clause would allow that investor to maintain their stake in a subsequent round by converting their shares ($5/share, doubling the amount of shares) at the price paid in the previous round. This provision can impair raises at higher valuations as certain investors may hold a disproportionate amount of shares, especially if the clause is used in an early round.

Weighted average dilution — This is an industry standard clause that protects the initial investor by taking into consideration for the difference in number of shares issued to a new investor at the current rounds price, versus the price of the previous rounds, and the degree of dilution incurred by the raise.

2. PROGRESSION OF A CAP TABLE:

As a start-up continues its trajectory, it may need to refuel on the way by raising more capital (recapitalize), but at the cost of founder equity (see Figure 2.). Here’s where cap tables can get very messy, especially when you have 50+ investors on the table, each having their own liquidation or dilution preferences.

Figure 4. Start-up financing cycle

2.1 Excessive Liquidation Preferences

Should each of these 50+ investors have their own liquidation or dilution preferences, the pressure this places on the equity value of the founder and options pool can easily crush founder and management equity stakes. Such a burden of preferences can lead to disincentivisation of the management team, and detract from the ability of the company to close new quality investors.

To prevent this, a founding team has two routes; 1) treat all investors equally and standardise liquidation preferences, or 2) have preferences stacked so the returns of the later investors are prioritised.

2.2 Participation Overhang

Though investors with participating preferences may stand to reap greater returns (see Figure.4), it poses a serious issue for later stage capital raises. New investors will rationally also take a participating stance as they may also gain higher returns, but these participating preferences stack up and dilute the equity value for existing shareholders as mentioned previously. As such, the industry standard for venture capital firms is to have non-participating liquidation preferences.

2.3 Events that change the cap table

Figure 5. Impacts of Events that change the Cap Table

2.4 Example: Series B Cap Table

Figure 6. Series B Cap Table

3. ANALYSIS:

Through a venture capital lens, the cap table’s purpose evolves from first clarifying that their are no red flags prior to an investment decision, then to scenario analysis should new investors buy-in or shares be issued, and lastly to a payout (waterfall) analysis to calculate their overall return on investment. The following will touch on each of these chapters of a cap table’s lifetime:

3.1 Red Flags

Here are some easier red flags to spot:

• Too many shareholders at an early stage startup
• Questionable or difficult shareholders with a non-trivial equity stake
• A small or non-existent ESOP pool at an early stage startup
• Low founder equity pool at an early stage startup

… and some harder flags to detect:

• Inconsistent and stacked liquidation preferences
• Crazy convertible note structures made in bridging rounds (e.g. Series A-2, A-3)

3.2 Scenario Analysis

Drawing back to Figure 3., 5. and 6. , scenario analysis can be used to understand the full effects of each of those events listed in Figure 5., and how a range of valuation metrics can change a funding round’s dynamics. Here’s an example using data tables:

Figure 7. Data Tables for Scenario Analysis

3.3 Waterfall Analysis

Lastly, waterfall analysis is used to calculate the payouts of all shareholders with all the following considerations taken into account:

• Options and warrants
• Conversion rights
• Participation rights and caps
• Cumulative dividends
• Liquidation preferences
• PIK dividends

In undertaking a waterfall analysis using the Cap Table, both investors and entrepreneurs will know where one another’s exit value stands should the event occur.

Figure 8. Aggregate Founder Waterfall Values By Stage ($m) (Source: Capshare)

Stay tuned for Cap Table 102, where we will go through the maths more in-depth.

For any questions in the meantime, feel free to reach out to me at:
kevin@airtree.vc

For more on understanding the mechanics of a Cap Table, check out:

Venture Deals by Brad Feld

Hidden Cap Table Secrets by Yael Elad, Aleph VC

Cap Table 101: Getting Down To Basics With Capshare CEO Jeron Paul, by Chris Rawle, Beehive Startups