A cap table, which provides a detailed accounting of who owns a business, can quickly grow complex for startups as they trade equity for capital. Maintaining an up-to-date cap table helps all shareholders keep track of their ownership at any point in time.
Key Points:
- A cap table is a type of ledger that provides a detailed accounting of who owns a business, and every incorporated entity has one.
- Every time a company raises new capital or issues stock to employees, the ledger needs to be updated.
- Addressing convertible securities in the cap table is essential to making decisions that are in the best interest of the founders, investors, and the business.
- Every line in the cap table tells a story about the company and investors use it to look for signs of potential growth and risks.
- Common red flags investors look for in cap tables include dead equity, uneven splits, and advisors.
For cash-burning startups that like to “move fast and break things”, taking the time to update a capitalization table is rarely at the top of founders’ to-do lists. While cap tables may be perceived as a mundane administrative task to deal with sometime in the future, the failure to understand and maintain one early in the startup journey can have unintended consequences for founders. To meet ambitious milestones, most startups must, at some point, trade equity for capital—or talent—causing the ownership structure to evolve and grow increasingly complex over time. It’s the cap table that offers a valuable snapshot of this information to guide critical decisions for scaling companies.
What is a cap table?
A cap table is a type of ledger that provides a detailed accounting of who owns a business. In fact, every incorporated entity has one. In the startup world, these ledgers are typically referred to as cap tables.
“A cap table can be as simple as a 50-50 split of ownership between two co-founders,” says Kory Henn, Assistant Vice President of Early Stage Banking at RBCx and a former early stage investor. “But what sets the cap table of a tech startup apart from more main street businesses is that they can grow in complexity over a relatively short period of time.”
Every time a company raises new capital or issues stock to employees, the ledger needs to be updated. Maintaining a current cap table helps all shareholders keep track of their ownership at any point in time.
How does a cap table work?
Updating a cap table in response to any change in ownership can be quite straight forward, even as the structure grows more complicated. “Every line on the cap table tells a story,” says Henn. “The funding history of the business, the way you split equity with your co-founders, how you compensate employees, who you’ve raised money from, and who is incentivized by the success of the business.”
The cap table for a startup with two cofounders can start simply as a 50-50 split in ownership, such as the example below:
| Shareholder | Number of Shares | % Ownership |
|---|---|---|
| Founder 1 | 500 | 50% |
| Founder 2 | 500 | 50% |
For illustrative purposes, let’s say the company raises new capital by selling 20% of the business to a VC fund. The updated cap table could look like this:
| Shareholder | Number of Shares | % Ownership |
|---|---|---|
| Founder 1 | 500 | 40% |
| Founder 2 | 500 | 40% |
| VC Fund | 250 | 20% |
While this is a simplified example, the ledgers can quickly change in complexity as more capital is raised.
“I find the founders who understand all this from a technical perspective are much better at negotiating with investors and understanding how they want to structure the deal,” says Henn. “They clearly understand that there’s a cost to the capital in the form of equity and how that dilutes their ownership.”
Where to start? Some founders use a spreadsheet, while others pay for a service. The capitalization table template provided by S3 Ventures is useful for startups through all stages of growth. Founders may also want legal assistance to ensure the ledger is set up properly with accurate calculations.
Regardless of how founders update their own cap tables, developing a deep understanding of how they work can be extremely valuable for modeling out various scenarios from the perspective of the founder or investor to help inform critical decisions.
Addressing SAFEs and convertible notes
An important thing to remember in cap tables is they only outline the ownership, which is defined as anyone who owns stock of the company. However, in early stage startups, the first round of investment isn’t always an equity round as many pre-seed and seed stage companies turn to SAFEs (simple agreements for future equity) or convertible notes for capital. Both vehicles are designed to convert into equity at a later date, rather than immediately. Does that mean these investments should appear on your cap table?
Because the holders of these documents are not actually shareholders, some founders may omit them from the cap table, but that’s not ideal. “A common surprise that occurs when these notes convert into equity is the amount of dilution the founders see all at once,” says Henn. That’s why addressing convertible securities in the cap table is essential to making decisions that are in the best interest of the founders, investors, and the business. The cap table template by S3 Ventures conveniently provides a framework to include convertible securities for founders and investors to model out scenarios and make informed decisions on funding, employee options and acquisition offers.
Example:
A company raises $750,000 on a $5 million post-money SAFE. This implies that the holders of the SAFE are entitled to 15% of the business upon conversion (before being diluted by new money). The conversion event is a $2 million seed round at a $10 million post-money valuation equal to 20% ownership for the investors.
When the deal is finalized, the company’s total dilution is impacted by both the SAFE and the seed round. Because the founders in this case didn’t account for the dilution from the SAFE holders finally receiving their shares, they end up with a dilution larger than the 20% they originally planned for when raising the $2 million.
The cap table template by S3 Ventures conveniently provides a framework to include convertible securities for founders and investors to model out scenarios and make informed decisions on funding, employee options and acquisition offers.
Common cap table red flags
The cap table tells a story about the company and is scrutinized by investors looking for tell-tale signs of potential growth and risks. Here are some red flags that may lead investors to think twice about investing in a startup.
Dead equity: This term is used when a significant portion of the cap table is allocated to a non-active party, such as a co-founder who leaves the business for a new opportunity. For example, if three co-founders own a business equally and one leaves for a new job, but continues to own 33% of the business, that block is considered “dead equity” on the cap table because it’s not contributing to the success of the business. Alternatively, that one-third of ownership could be better utilized by re-distributing it among the remaining co-founders, directing it to the ESOP, or reducing dilution when raising new capital. The absent co-founder, meanwhile, still has a meaningful impact on governance decisions and matters that require a shareholder vote. Investors commonly advise co-founders to enter into vesting agreements that can mitigate problems should one individual move on.
Uneven splits: An uneven equity split among co-founders can be a red flag because equity ownership helps define incentives. When a co-founder has less equity than another, investors may ask if they will be equally incentivised? Will they want to work equally as hard and make the same trade-offs?
“Uneven splits tell you a lot about how the founders value each other’s contributions and how they think about the business long term” says Henn.
“I often see founders explain these splits with reasons, such as ‘I came up with the idea’ or ‘I developed the core IP’,” says Henn. “I tend to think this is short-sighted. In the early days of starting a business that you will spend the next seven or so years on, it’s important to get things right from the start.”
Advisors on the cap table: Advisors can play an important role, but founders should be cautious about who receives equity, and what you get in exchange for it. Seeing advisors on the cap table can be a concern to potential investors.
“In my experience, the best advisors don’t ask for equity. They ask to invest instead,” says Henn. “Usually when I see advisors with 10 per cent ownership or unusual equity agreements that outline what is essentially ‘payment for time’, it almost always causes problems when trying to close a round.” Investors may question the value advisors bring to the company, and why they don’t simply join the company if they want to be a part of it.
Founders that invest the time to understand cap tables may be better equipped to lead their companies to long-term success. A clearly articulated ownership structure that’s up-to-date can help guide critical business decisions and negotiations with investors as the need for capital grows.
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