Startup founders and business owners are usually aware of the concept of a cap table, but only really face having to deal with theirs when they come to raise capital and a prospective investor asks for a copy of their cap table. At that point, what ensues is a rush to produce something in an acceptable form for that investor, often without having a full understanding of the purpose of the cap table or with errors creeping in. This article is a guide to cap tables and explains the concept and practicalities of a cap table.
What is a Cap Table?
Every company is owned by a variety of different entities, each of whom has some rights to it. A cap table in its most basic form is merely a record of this ownership.
For example, there are the founders who often hold the majority of shares; sometimes there are family or friends who own ordinary shares or even early investors who were granted preference shares. As well as these, there may be other investors who own convertible notes in the company (these are loans that may convert to shares in the company under certain circumstances) and employees who have been granted share options.
What all of these examples have in common is that they currently or potentially own a proportion of the capital of the company. The purpose of a cap table (or capitalisation table) is to record these rights in a single, internally consistent document that anybody can look at and see who is entitled to what share of the company under what circumstances.
What Does A Cap Table Look Like?
A company’s cap table will often start off incredibly simple. Consider a new company formed by two founders each holding 500 ordinary shares (thus 1,000 issued in total). The cap table for this company would look like this:
Now imagine the company needs to raise some money for growth and does so by issuing a number of convertible notes to a single investor with a face value of $75,000. These are not shares now, but they may convert to shares in future so they need to be recorded in the cap table since they may affect ownership of the company. These would be recorded in a separate section of the cap table, together with the important details of the convertible notes (for example, any interest, discount of valuation cap that may be recorded in a separate section).
At this stage, the convertible notes cannot be expressed in terms of a number of shares since they have not converted yet. We will only know at the time they convert how many shares they will convert into since that will depend on the share price at the time of conversion (more on this later).
Now suppose that the company wants to incentivise a few of its key employees so grants them options on shares. Again, these are not currently shares since the employees have not exercised them yet, but they are potentially (ordinary) shares if exercised so also need to be recorded in the cap table. They are slightly different from the convertible notes, however, in that we know how many shares would be issued if all the employees exercised their options.
|Shareholder||Shares||%age held||diluted %age|
|Options||Shares||%age held||diluted %age|
|Investor A||$75,000||No interest, 20% discount, no cap|
Here we have introduced the concept of dilution. If both the employees exercise their right to purchase shares and the company thus issues 500 new shares to them, this will have “diluted” the founders. The founders will still own 1,000 shares between them, but this will now be out of a total of 1,500 shares.
Hence, many cap tables will be presented with a percentage held based on the currently issued shares and also a percentage held on a “diluted” basis as we have done in the right hand column above. You may also come across the terminology “fully diluted holding” or similar, which means that all such options (including those that are part of an employee share scheme but have not even been granted yet) are taken into account when calculating the percentage. This should then represent a worse case for the founders in terms of dilution (other than for convertible notes and other instruments that cannot be modelled explicitly at that stage).
As you can see, a cap table can very quickly become relatively complicated and understanding the implications of the various entries and how they interact with one another can become confusing if not carefully managed.
The next stage that a cap table is often developed for is to be able to model what happens if there is a future round of investment. Investors will often carry out such modeling to establish what their returns might be under different scenarios.
However, founders and other current investors should also be interested in the same information. For example, an assumptions might be made as to the pre-money valuation of the business and an investment amount from the new investors for a certain number of shares.
A sophisticated cap table would be able to tell you what the new cap table of the company would look like after the investment. For example, as well as current share holdings, it could assume that options were exercised on such a liquidity event or that convertible notes were converted to shares. It would also allow for any new employee share option pool that was to be set up following the investment round.
Ultimately, a cap table could also be used to predict the payout that individual founders, investors or employees might earn if there were to be an exit in future, but this requires more assumptions.
From the company’s point of view, the cap table is a record of all the current holders of shares and instruments that could convert to shares. Having such a record is essential to:
- run the company effectively – for example to ensure that all appropriate people are kept informed of company changes;
- understanding the impact of decisions on the company, particularly those that will affect the company’s share capital – for example raising further finance through shares or deciding to implement an employee share scheme; and
- identify what groups of members could form a majority in member votes (and how this could change with options being exercised or new investment).
From a potential investor’s point of view, they will want to be able to work out what any investment they may make in the company will transform into in terms of possible payouts and to do that they will need to be able to understand and use the company’s current cap table. Investors can be put off by untidy cap tables, both in terms of the presentational style, but also in the variety and types of interests present in it.
Having too many different shareholders, option holders and noteholders all with instruments carrying differing rights can make it more complicated to value their investment, but could also be considered suggestive of disorganised founders who have previously raised money in a haphazard fashion. Thus taking simple steps to managing your cap table effectively can be an important part of making yourself more investible.
Holding a cap table does not replace the need to meet the regulatory requirements set out in the Corporations Act 2001 (Cth) and related legislation. For example, there is a requirement for proprietary companies to inform ASIC (the Australian Securities & Investment Commission) if there is a change in the shareholders of the company. There are further requirements to maintain records of members, option holders and some note holders and a suitably set up cap table can be arranged to meet these requirements. This can be helpful in ensuring that data held for all purposes is consistent.
A cap table records the owners (or potential owners) of capital in a company. It can thus be used to establish who owns what percentage of the company in different circumstances (including fully diluted). Further, it is likely to be requested by investors who will also use it to make decisions on their investment. Thus it is important to get on top of your cap table early by recording all the relevant holdings and then to manage it carefully on an ongoing basis.