A guide to cap tables for the busy founder.
A capitalization table or ‘cap table’ is a document that details the overall ownership stakes in a startup allowing its capital structure to be understood at a glance. Simply put, your cap table describes who owns what and potential investors will ask for a copy when you ask them for money. There are many useful articles on the web that provide a good overview of cap tables. Here are some relevant examples that we like.
- The startup’s guide to cap table management.
- Venture hacks on cap tables.
- Funder’s club on convertible notes.
Most of the online resources we have seen to date are broad overviews, often targeted at founders preparing to raise their first equity round. However, in conversation with early founders we often hear the question ‘What do I need to do today, and what can I leave for later?’ Early-stage founders tend to be time-constrained and are constantly balancing what is urgent, what is important and what can wait until tomorrow.
This post outlines five recognizable stages of startup growth and the cap table related ‘stuff’ that you need to care about at each stage. Our goal is to help you focus on what’s important now and help you avoid costly cap table related mistakes down the road.
- Step 1: Pre-formation
- Step 2: Company formation
- Step 3: First employees
- Step 4: Seed stage (pre-first equity)
- Step 5: First equity round (Series A)
Step 1: Pre-formation
This initial stage is when you are exploring an idea, are perhaps even starting to build something but have not yet registered as a company.
Decisions on who owns what are typically casual and verbal, e.g., a 50:50 spilt. You are working on the project part-time, in evenings and weekends and have no employees yet. At this early stage a cap table can be overkill but if you are not working solo there are some small but important preparatory details that are worth spending time on.
- Discuss with your co-founder(s) and come to a preliminary agreement on what the initial ownership split of the company will be. E.g 50:50.
- Discuss the founder vesting structure. A 48 month vesting schedule is typical. Often there is a short waiting period (less than 12 months) before any stock is vested. Also, if one founder started working on the project before the other it is reasonable for their vesting schedule to reflect the earlier start date.
- If you or your co-founders are investing or lending personal funds discuss the terms of this investment and how it should impact company ownership.
This may or may not be an uncomfortable conversation at this early stage but it will certainly help avoid fundamental disconnects on contribution or ownership later on. Capture your discussion and record it in a document or email thread.
Another good use of time at this early stage is to begin to document the company IP — that which you sell to the company you are about to form in return for founder equity. When you incorporate you will need this IP documented.
Step 2: Company formation
Incorporating a company that you plan to VC fund later on is best done with the help of an attorney. They will advise you on the business entity type that best fits your needs, which US state to incorporate in and guide you through the incorporation process.
A key benefit of being a co-founder or early employee is the possibility of filing an 83b election with the IRS. Filing can dramatically reduce the taxes you pay as the company value grows and can make buying your stock affordable if you choose to leave before a liquidity event. Here is a good explanation of 83b elections. Anyone with stock subject to the Company’s repurchase option (aka deferred compensation) can benefit from filing an 83b election.
After incorporation, but before you have any employees or advisors your company equity structure is still relatively simple. Your cap table will typically summarize the following:
- Company formation date.
- Amount of shares authorized (This is the total number of shares that the Company “could” currently issue.)
- Amount of stock issued to each founder, vesting schedule and individual start date.
- Which founders have filed an 83b election with the IRS.
- Amount of stock in the employee option pool. When you are creating an “authorized” pool and “issued” pool of stock consider how many shares you might have to issue to employees and consultants in the next twelve months.
It is important to note that your cap table is only a summary not a legal document. Your cap table only summarizes stock, option and warrant issuances that are recorded in separate, board-approved documents such as stock purchase agreements, stock option agreements, etc.
Founders will often record information in their cap table in advance of approval but it is vitally important to make these entries official as soon as possible and to update the cap table with correct dates. Shares are not officially issued until the Board approves them and both the grantee/purchaser and Company sign the stock purchase agreement.
Here is a good checklist of key further steps after incorporation.
Step 3: First employees
Stock and stock options are an important means of compensating employees, advisors and consultants. Your cap table can be useful in this process in two main ways.
- Firstly, by summarizing all stock options that have been granted to date your cap table is a useful tool for managing your option pool, for knowing who has been granted what, how they will vest and also for making sure you are keeping within plan — that you don’t make the mistake of granting more options than are currently authorized.
- Secondly, as you decide what is a fair offer for each contributor the cap table is a useful tool for comparing grants — for thinking through what each person is contributing to company success and for ensuring that offers are proportionate.
A strong piece of advice from Kathryn Montalvo at Orrick is to define an offer in absolute numbers of shares instead of as a percentage of the company. Percentages are ambiguous and quickly become inaccurate as the company grows. Informing a prospective new employee that their offer is equivalent to a certain percentage of the company can be helpful context but he/she should be made aware that the percentage is not fixed and will likely be diluted over time.
Typically startups grant restricted stock from the employee stock plan until such time that the company has raised an equity financing. Only then do they spend the cash to obtain a 409A valuation and move to granting stock options instead of restricted stock.
A 409A valuation addresses the risk of the IRS arguing with you at a later point on the value of the stock and what taxes people owe. The cost of a valuation is approx. $2,000 and some places may offer this service for free (eg: SVB) as part of relationship building.
Employees benefit more from restricted stock than they do from options. So if you want to be employee friendly, you give them restricted stock as long as you can and as long as par value or 409a value is negligible. However, restricted shares impose a small admin burden. If you don’t take the proper steps when the employee leaves to reclaim the unvested shares, then they default to receiving them.
If you are pre-equity and are still granting restricted stock make sure to note in your cap table which employees have filed an 83b election.
In addition to recording new employee grants it’s also important to record the details of any employees or founders who have moved on, specifically how many options were vested and how many were exercised by the employee upon leaving and/or bought back from the employee by the company.
Step 4: Seed stage (pre-first equity)
Where you are starting to raise seed capital via convertible notes, bridge rounds, etc but are not yet at Series A.
This stage is where CEOs start to pay more attention to their cap table, largely because potential investors are asking to see it. When looking at your cap table a seed-stage or ‘angel’ investor is looking out for:
- Who owns what — is the team incentivized to both work hard and see the project through.
- What other notes, warrants, etc are in place and how will they convert at Series A?
- How much of the employee option pool has already been issued and how much remains to support the hiring plan.
When you close a convertible note it is important to record it’s conversion features in your cap table. Notes and other pre-equity instruments like warrants and SAFE typically have a number of features that determine how they convert to equity upon a future equity financing. A note’s ‘discount’ or it’s ‘cap’ multiplies it’s buying power during a subsequent Series A round rewarding the seed stage investor for their early bet.
These features can have dramatic and non-intuitive effects during an a round. In addition to seeking good advice it’s wise to explore a number of equity financing scenarios and calculate how each convertible note will convert based on it’s features. Captable.io includes an easy to use feature for round modeling, including the impact of convertible notes.
Step 5: First equity round (Series A)
Once you decide to raise capital and assuming you have gotten some investors interested, you need to think about how much money you need and how much of your company you are willing to give in exchange.
Seated on the other side of the negotiation table your potential investor has an opinion on your exit value, chance of success, what percentage they want to own and how much they are prepared to pay for it. During negotiation your cap table is very important.
- Firstly, your cap table needs to be 100% in order and accurate. Any softness here is a red flag to a potential investor. Also, if errors come to light during the process these can delay closing the round or serve as a negotiation point for the investor to use to drive a harder bargain.
- Secondly, by exploring a range of scenarios you can decide what is negotiable, what is off the table and what your limits are. You can use your cap table to be better prepared to negotiate a deal that is right for you and your company. It can be helpful to think backwards from a potential exit, which is why we incorporated an exit modeling tool into captable.io.
John Bautista, head of the Technology Companies Group at Orrick cautions founders raising their first equity round on what is known as ‘the option pool shuffle’. If the current employee option pool is deemed insufficient by your investors they can ask for more options to be authorized, diluting your stake in the company, but not theirs. Here is a good post on the option pool shuffle.
In conclusion, there are a few key behaviors around your cap table that can make the difference between smooth sailing and an embarrassing and costly repair job on your companies capital structure.
- Keep track. Your cap table is not the document of record but it is an important summary of those documents. Adopt a regular cadence of keeping your table updated with the latest grants, convertible notes, etc. Omitting even one grant or note can delay or threaten your series A. Conversely, make sure that all transactions in your table are real and have been approved by your board.
- Keep everybody on the same page. Mismatched expectations due to a misremembered promise, a clerical error or a financially unsophisticated employee can lead to rifts, disappointment and even legal action. This concern is behind the verify feature in captable.io.
- Keep the endgame in mind. When deciding on co-founder vesting schedules, the terms of a convertible note or how much cash to raise, you need to know how this may effect the eventual outcomes for you and your people. This is why we built the round and exit modeling features in captable.io