When angel investing in startups, it is important to know who the owners in the company are and what they own. This is where capitalization tables, or “cap tables” as they are commonly known, come in.
What is a cap table?
A cap table is simply a record of all stock already issued or available and identifies all stockholders and how much they own. The ownership of a startup changes as it grows and progresses through its funding rounds. This can occur with new investors buying in, stock options being exercised, or convertible notes being converted to stock. The cap table is used to track these changes and keep a record of all the current and potential shareholding in a company.
Authorized Shares vs Issued Shares
Before digging into the details of a cap table, it is important to understand the shareholding structure of a startup. When a startup is formed, the total number of shares the company can create is defined in the articles of incorporation. These are known as Authorized Shares.
When a company is formed, the number of Authorized Shares can be just about anything (within reason) and is decided upon by the company founders. In startup land, 10 million Authorized Shares is a common number.
Once the startup is formed, some of the Authorized Shares are issued to people involved in the company such as the founders, making them shareholders with a stake in the potential success of the company. These shares are known as Issued Shares. Another commonly used term for shares that have been issued and are held by stockholders is Outstanding Shares.
Startups generally allocate a portion of the Authorized Shares for future investors and for employee stock options (which provide the holder a right to purchase shares at an agreed price at a future date) to incentivize staff. These allocations are vital elements to support the growth, development, and success of the startup.
Dilution of shareholding
When considering the capital structure and shareholding of a company, it is important to understand the concept of dilution because this can have a major impact on the ownership stake of founders, investors, and employees.
At any point in time, a shareholder owns a percentage of the company based on how many of the Issued Shares they own. For example, let us say a startup created 10m Authorized Shares and issued 8m of those shares, holding back 2m shares for future investment. If 3.6m of the Issued Shares were allocated to one of the founders, this would mean they own 45% of the company (3.6m divided by 8m Issued Shares) at that time. But then once the additional 2m shares are issued to investors from the Authorized Shares pool in a subsequent funding round, then the founder’s ownership stake would be diluted to 36% (3.6m divided by 10m Issued Shares).
Extending the dilution concept further, it is important to remember that shares in a company can be created effectively out of thin air. The company’s board of directors or a shareholder majority can vote to authorize additional shares to seek additional funding or allocate stock options to attract key staff. Further dilution would occur as a consequence of additional Authorized Shares being approved. Going back to our hypothetical founder with 3.6m shares, if another 2m shares were authorized and subsequently issued, the company would now have a total of 12m Issued Shares. In this case, the founder’s original number of shares remains the same at 3.6m, but their percentage ownership goes down from 36% to 30% (3.6m/12m).
So, in this dilution example, the founder’s ownership stake that started at 45% has now decreased to 30%.
Why do I need a cap table?
A cap table is important because it identifies all stockholders in a company. It tells a story of who has potential influence and control in the company and shows the potential effect of future share issues and fundraising rounds.
Another important function served by a cap table is for use in company valuations under Section 409A of the United States Internal Revenue Code, which provides a mechanism for an independent evaluation to determine a fair market value for the stock.
Cap tables are also a vital tool when carrying out a waterfall analysis or scenario modeling of capital distributions in a liquidity event. Waterfall analysis identifies the sequence and amounts for return of capital to the various lenders, investors, and stockholders, recognizing the rights and interests of the various parties, which are rarely equal.
Remember that cap tables are only part of the picture when it comes to investing in startups, so it is important to expand your knowledge about becoming an angel investor.
Cap table example
To illustrate the main concepts of a cap table, let us work through a very simple hypothetical example based on a startup that created 10m Authorized Shares, issued 72% of the shares to two co-founders with a 50/50 split each, and then allocated 8% of the shares for Employee Stock Options and 20% of the shares for future investors. A simple cap table outlining this scenario is shown below. Note in any cap table, it is important to show percentage ownership not only of Issued Shares but also on a “fully diluted” basis, i.e. as if all Authorized Shares were issued.
|Name||Issued Shares||Authorized but Not Issued||Total Shares||Percent of Issued||Percent Fully Diluted|
This table is for illustrative purposes only and does imply or guarantee any type of future return.
Understanding a cap table
The hypothetical example cap table provided above is a very simple version to illustrate the main concepts and structure that might exist in the early stages of a startup. A cap table in a real investment situation may include more detail such as valuation, share price, type of stock, funding rounds, debt, liquidation preferences, liquidation multiples, interest, dividends, and more.
It will take time and education to understand cap tables in detail, but as an investor it is so important for you to reach this stage so you can understand what you will be getting into when you take on an angel investment, and what impact the information in the cap table can have on your investment.
You can find more information here on how to start angel investing.
Key terms in cap table analysis
The three main categories of terms used in cap table analysis are Valuations, Security Types, and Share Counts. Each of these categories have their own collection of terms, some of which are highlighted in the following table (not an exhaustive list).
|Valuations||Pre-money valuation||The value of a company prior to an investment or funding round.|
|Post-money valuation||Calculated as the pre-money valuation plus the new investment that then hits the company balance sheet as cash. For example, if a startup’s pre-money valuation was $2m and an investment of $500k was injected into the business, then the post-money valuation would be $2.5m|
|Stock price||Calculated by dividing the post-money valuation by the number of fully diluted shares, e.g. 10m shares on a post-money valuation of $2.5m means a stock price of $0.25 per share.|
|Security Types||Preferred stock||A class of stock with special rights that allows the holder to exercise a liquidation preference and be paid before a holder of common stock in a liquidation scenario.|
|Common stock||Offered by all publicly listed companies, it is the type of stock most commonly purchased by investors, which gives them an ownership stake in the company. When it comes to startups, investors usually invest in Preferred Stock. Common stock is usually owned by founders, or obtained by exercising stock options or warrants.|
|Participating preferred||During a liquidity event, participating preferred stockholders can receive their liquidation preference at the agreed multiple of the original purchase price (e.g. 1X, 2X, etc.) and then also participate in the deal as a common shareholder. This is also known as “double dipping”.|
|Convertible note||Debt that converts to equity at some point in the future where the lender is repaid in company stock.|
|Simple agreement for future equity||A SAFE functions like a convertible note but without the debt, where an investor contributes cash into a startup in return for a right to convert to stock at an agreed price when an agreed event occurs.|
|Stock options||A right to purchase stock at a predetermined price, irrespective of the current stock price at the time of purchase.|
|Share Counts||Authorized shares||The total number of shares that can legally be created by a company.|
|Issued shares||The number of shares that have been issued to specific stockholders (also called Outstanding Shares).|
|Fully diluted shares||The total number of shares that would exist if all possible shares and options were issued.|
How cap tables are used
Cap tables are used by new investors to evaluate the stock structure and the investment opportunity for potential returns and risks.. Another key area of application for cap tables is when hiring key staff because it presents a transparent record of the equity structure and the potential value of employee stock options.
Finally, cap tables are an important record showing the payment amounts and priorities to all stockholders in a liquidity event.
Waterfall analysis is an important tool used to forecast the return for stockholders on the cap table under potential liquidity scenarios. If a liquidity event such as a sale occurs but the valuation is uncertain, waterfall analysis can identify important trigger points and thresholds in the valuation and the effect these would have on all stockholders.
Managing your cap table
Cap tables can get very complicated, very quickly. Complex cap tables with lots of detail are required for large companies with multiple funding rounds, a big investor pool, and various funding instruments such as convertible notes, simple agreement for future equity, and preferred stock multiples. Cap tables are often managed by lawyers or accounting firms who specialize in startups. Initially, Excel spreadsheets are often used to develop cap tables, but there is also special cap table software available once the complexity increases.
However it is done, it is critical for founders and investors alike that a cap table is always kept up to date with the latest information, and there is always a single source of truth detailing precisely who owns what stock in the company. Assigning responsibility to a single party as the recognized holder of the true record is an essential part of managing the cap table to ensure it is always current. Communication is also important, especially deciding how detailed is the information you share with investors and employees because this can have an impact on the ongoing funding or staffing of the startup.
Investors should keep in mind that these are high-risk investments and past performance is not a guarantee of future performance. These investments are illiquid and there is no guarantee that an exit strategy will come to pass and investors can lose all of the money invested.
Check out this link for more information on how to invest in startups.