By Elena Vrabie
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Maintaining a functioning and up-to-date cap table is an important part of a company’s operations, particularly for a company that plans for growth. In the early days of a startup, tracking the equity ownership percentage in the company is relatively easy. There are rarely more than five shareholders and the number of shares they each own is easy to track. However, as a company grows, the company’s ownership structure, and therefore, its cap table, becomes more complex. Below are a few tips to help with better managing a startup’s cap table.
Do not use an excel spreadsheet solely to calculate your cap table. Use equity management tools.
Using excel spreadsheets alone to calculate your cap table can be extremely tedious. It requires you to manually input your data, learn the necessary excel formula, double-check your calculations, and even sometimes, validate your figures with a calculator – only to still end up with some errors on the cap table or even a situation where the cap table calculation is right but the numbers conflict with the company’s legal documents.
Unfortunately, this is very common and we’ve helped numerous clients in cleaning up their cap table after they granted more shares than they were authorized to grant. The good news is that there’s a better method of calculating your cap table to set your company up for success! Companies’ can now automate their cap table via the different equity management tools that exist. Some of the more popular ones are Shareworks, Carta, Pulley, and Captable.io. With these tools, all the company needs to do is input their data correctly into the software and the software prepares the cap table automatically. On these types of software you can input the different types of equity – common, preferred, warrants, convertible securities; factor in different vesting schedules for stock grants; terminate stock option grants; convert convertible notes and SAFEs to common shares; calculate waterfalls and what-if scenarios to model dilution in preparation for investor negotiations. The best part is you can then export your cap table from the software with all of this information as an excel spreadsheet, i.e., you get the end result without having to labor manually over an excel spreadsheet.
Avoid rounding errors when calculating the price per share in the Pro-forma cap table.
A common issue we’ve come across during equity rounds of financing is rounding errors. We find that Pro-forma cap tables are calculated manually via an excel spreadsheet and one key function of the excel spreadsheet is rounding up numbers. When calculating the preferred shares to be issued to an investor upon financing, the first step is to calculate the price per share (PPS) – usually by dividing the company’s pre-money valuation by the fully diluted capitalization of the company prior to the investment. The sum of this is usually a fractional number, for example, where the pre-money valuation of a company is $69,000,000.00 and the fully diluted capital of the company prior to the investment is 11,517,919, the PPS would be $5.990665501294114. However, we find that most companies, using the rounding up function of the excel spreadsheet, would round this number up to $5.99. This could lead to future problems for both the company and the investors. First, the investor is acquiring more shares for less than they are worth – An investor investing $9,000,000 at a PPS of $5.990665501294114 gets 1,502,337 shares while one investing $9,000,000 at a PPS of $5.99 gets 1,502,504 shares – i.e., the investor gets an additional 167 shares by using the rounded-up PPS, which is detrimental to the company. Secondly, a rounding error on the Pro-forma cap table can also affect the amount the investor is wiring in for the financing and therefore the amount the investor receives upon an exit. Using the above figures (i.e., a PPS of $5.990665501294114 x 1,502,337 shares), the exact amount to be wired in is actually not $9,000,000 but $8,999,998.44. Usually, the liquidation price for an investor is calculated as 1x the PPS, therefore, when calculating what the investor is entitled to at an exit, what’s used is $8,999,998.44 and not $9,000,000, i.e., $1.56 is lost to the investor forever. It is very important to avoid rounding errors when preparing your cap table to prevent any of these scenarios from taking place.
Always have one person knowledgeable in cap table mathematics manage the cap table.
Whether or not the company chooses to automate the cap table, it is important it is managed by a person that understands both the mathematics involved in calculating the cap table and the company’s legal documents. It is our view that the cap table should be jointly managed by a lawyer with startup and venture finance experience and one senior management member of the company. The management member provides the company’s equity information while the lawyer provides the mathematical and legal expertise and both act as a form of check and balance for the other person. Cap table calculation is a delicate procedure that requires mathematical precision and attentiveness. It is not unusual for mistakes to occur if only one person is managing the cap table, and two pairs of eyes would help catch most mistakes. Lastly, the cap table contains private information – names of the company’s stockholder, number of shares held by the respective shareholders, and sometimes, email and address of the shareholders. One advantage of having fewer persons managing the cap table is that it’s easier to maintain confidentiality.
Where the cap table is managed by two persons, never update without informing the other party.
It is important that where two or more persons are managing the cap table, each party be notified before any change to the cap table is made, otherwise, the person making the changes to the cap table can make it unrecognizable to the others, which would lead to more time and expense down the road when trying to reconcile the cap table with the legal documents. Once, a client of ours with editing access to the automated cap table system made copious changes on it without notifying us or providing us with the legal documents that led to such changes. As a result, the cap table was riddled with errors, which then led to intensely reconciling back and forth the cap table with the legal documents. Those were billable hours that could have been avoided by the company if we had been informed prior to such changes and caught the errors early on.
Understand the cap table and necessary terms before engaging in investor negotiations.
We always advise founders to understand their cap table before entering negotiations with investors. Whether or not you conclude your next deal with an investor on a napkin during lunch, in an elevator pitch, or even after an incubator or accelerator pitch, it is important that you understand the cap table and the terms the company is willing to agree to. For instance, understanding what the fully diluted capitalization of the company is (i.e., number of issued and outstanding shares of the Company’s capital stock, assuming the conversion or exercise of all of the Company’s outstanding convertible or exercisable securities, such as preferred stock and all outstanding options or warrants) and your percentage of that fully diluted capitalization will help direct the discussion on what percentage you’re willing to give the investors. For instance, if you are unwilling to have less than 20% of the fully diluted capitalization of the company, and you currently have 25%, – by understanding the cap table, you would only negotiate a deal that places you above 20% and avoid any deal that places you below 20% ownership. Also, even if you happen to negotiate a deal with an investor on a napkin, it is always advisable to pause on finalizing the deal until after running the numbers on an excel spreadsheet or an automated cap table system to prevent basic calculation errors and make the process transparent both for the investors and founders. This would effectively reduce the closing costs down the road.
Always keep the cap table up-to-date and ensure the cap table matches with legal documents.
The cap table is an evolving document. As the company grows, so should its cap table evolve. Every time a grant is made by the company, the cap table should be updated. Do not leave for later anything that can and should be done now. For example, where an employee’s vesting terminates, this should be reflected on the cap table immediately, whether it is an automated cap table system or not. This is because updating the cap table immediately when a grant or an event takes place would help catch any errors or missing signatures in the legal document sooner rather than later. Additionally, this would reduce the risk of human errors in the cap table itself – because the later a cap table is updated, the easier it is to forget to update or to update the wrong information. Therefore, it is important to always maintain an accurate, up-to-date record of share grants, expiry dates, and exercise windows, and update regularly with additions, deletions, or adjustments to the company’s securities.
Do a cap table audit and clean up all historic documents before any financing or corporate transaction.
A cap table is similar to and equally as important as a company’s balance sheet which keeps track of a company’s assets and liabilities. Therefore, it is important that the company performs a regular audit of the cap table to ensure that it is up-to-date and complies with the company’s legal documents. Auditing the cap table is to ensure that the details inputted into the cap table (e.g., the name of shareholders, number of shares or options, date of grant, etc.) were properly authorized by the board and the shareholders. It will also ensure that there are no conflicts between what was inputted into the cap table and what is contained in the transactional documents (i.e., the agreement executed by the parties). But most importantly, this would ensure that the company does not grant shares to investors or employees that are more than the number of shares the company is authorized to grant. Auditing of the cap table can be done monthly, quarterly, or annually. It must however be done before the company takes part in any corporate transaction, e.g., financing, merger or acquisition, or IPO. This would give the company time to catch and engage legal counsel to correct any errors on the cap table or in the historic legal and transactional documents. Nothing screams red flags to an investor louder than a potential portfolio company having inaccurate legal documents and/or an incorrect cap table.
Circulate only one version of the cap table for financing and update just that version, if necessary.
It is really important to maintain one source for the company’s equity. This would ensure that the company circulates only one version of the cap table to the investors during the financing. This helps to prevent multiple versions of the cap table from circulating during financing and leading to confusion on which version is the correct version. Most importantly, it will reduce the occurrence of a lack of version control because if the investors doubt the accuracy of their version, they would be able to track any changes made to the initial version during the negotiations of the financing. Another thing to be agreed upon is who circulates the Pro-forma cap table? The company? Company’s counsel? Or the investors (i.e., after having their financial analyst make the calculations)? It is very important to define this role early on to ensure that the party preparing the Pro-forma cap table is one that understands the necessary mathematics. In a recent deal, the company’s in-house counsel prepared the Pro-forma cap table without an understanding of what it entails, leading to multiple corrections from the investors and outside counsel. If the issue of who circulates the Pro-forma cap table was raised earlier, it would have come up during the discussions that the in-house counsel was not the suitable person to prepare and circulate the Pro-forma cap table and this responsibility would have been designated to a more fitting party.
Understand how to convert convertible securities and always factor in convertible securities on the cap table.
One of the things to understand when managing a cap table is convertible securities (i.e., Convertible notes, SAFEs) and how they affect the cap table. Even when convertible securities have not been converted to equity, it is important that they are represented on the cap table. This will ensure that the cap table contains an accurate visual representation of the company’s equity and debt structure. Any investor looking at a company’s cap table wants to be informed if the company has any existing convertible securities that would dilute its investments in the future. A disadvantage of not including convertible securities on the cap table is the possibility of (i) forgetting it exists and (ii) not converting when all conditions for the conversions are met. Unfortunately, as bizarre as this sounds, we have seen this happen. Also, most convertible notes or SAFEs come with discounts and/or valuation caps which may create an assortment of PPS for the same type of shares during the same financing round. For example, for a convertible note with a 20% discount, if the original PPS is $1.00, the investor holding the convertible note would have a discounted PPS of $0.80, i.e., without the discount, an investment of $10.00 at $1.00 PPS gets 10 shares while, with the discount, an investment of $10.00 at $0.80 PPS gets 12.5 shares. It is important that all of this is accurately represented on the cap table to ensure that the holder of the discounted convertible notes does not purchase the shares at the non-discounted rate.
For multiple financing – always factor in all closings in the Pro-forma cap table
Some equity financing rounds have multiple closings, e.g., the investors may agree to first invest the sum of $7,000,000 and then an extra $3,000,000 within a period of time, usually 6 months (after the company achieves a predetermined set of KPIs), making it a total financing round of $10,000,000. When preparing the cap table for such a round, it is important to include all of the projected equity the investors will be issued after both closings, i.e., factor in the total $10,000,000. With this, both the company and the investors are well aware from the first closing what each party’s share ownership would be in the company after the final closing. This would prevent a need for further negotiations after the first closing.
Ultimately, there isn’t a right way to manage a company cap table. However, the above information contains tricks of the trade to help a company in managing its cap table to set itself up for success. At a basic level, the cap table should contain all of the company’s equity structure, and should always be accurate and up-to-date to effectively record the company’s maturity. A well-managed cap table will save the company time and expenses and prevent unpleasant surprises when entering into a corporate transaction.