In part I of this series, we looked at understanding the importance and value of cap tables. Now, in Part II, we will look at funding rounds and structuring cap table models with the flexibility to allow investors and businesses to understand the impact of raises and returns on capital.
Series A, seed funding, founders round—what are all of these rounds and how do they impact the cap table?
As start-up and early stage companies grow, they require funding to pay for operations, including the talent they employ, funds needed to scale up, and to take advantage of new opportunities. While many of these businesses begin with capital raised by the original founders, friends and family—eventually as businesses grow, they begin to look to outside investors for greater capital to fund their growth.
So, how many rounds are there? What is the purpose of each round? Below is a primer on the typical funding rounds:
- pre-seed funding: this funding round is used where a founder(s) has an idea for a business or product and require funding to develop it further (i.e., creating a prototype, testing through market research, etc.) Contributors to this round are usually the founders themselves as well as friends and family
- seed funding: this funding round helps a company in the initial stages with market research and product development
- series A: this funding round usually begins when a business has a track record of revenues, a customer base, or other key indicators of success. In order to successfully raise Series A funds, a business requires a well-thought-out strategy to demonstrate how it will monetize its plans
- series B: this funding round is usually used to grow the business further and reach new markets or meet increased demand. A business looking for Series B funding is past the early development stages
- series C: this funding round is usually used by a company that is already successful and looking to expand quickly, such as through an acquisition
Cap table models should guide decisions related to funding rounds, valuation and dilution
Flexible cap table models can be used to illustrate proposed or projected transactions, such as additional financing rounds, IPOs and exit sales. You should be able to quickly run scenarios that reflect various dates, valuations and funding amounts, as shown below. If you are creating additional options or warrants, you will want to understand the potential dilution on existing investors as well as play with vesting requirements, strike prices, or valuation caps.
Simplified example: A flexible model will have a user-friendly template in order to sensitize the model for additional funding rounds.
Data table, data table, data table
If you’ve read any of my previous articles, you will know that I am a huge fan of the data table. What better way to see the impact of multiple variables on an outcome without having to run multiple scenarios?
The better cap table models will show returns such as ROI and IRR to each funding round, investor or executive sensitized for multiple variables. These can be calculated using a current valuation of the business, projected valuations or exit values.
The below example illustrates what the data table for Series B would look like under various exit values and exit dates. The model is built to provide insight into the returns to each funding round and allows investors to understand what the potential investment might return.
Use of cap table models to guide in decisions related to granting of options and warrants
Businesses in start-up or growth phases will use options and warrants to entice suppliers, employees and others to take a risk and provide services with less upfront return—but a potential for more return on the back end if successful.
A flexible cap table model allows a company to demonstrate this upside potential to those they wish to retain. This can be done by illustrating returns under various exit values and exit dates such as above.
A common use of granting options is when a new company offers them to their employees and executive group. The risk to an employee or executive in working for a start-up business is higher than working for an established business. Those that join are typically looking for high returns to compensate for the risk they are taking. In the early stages where a company lacks liquidity to compensate adequately relative to the risk being taken, many companies turn to options and warrants to sweeten the deal for employees. A cap table model can be used by the company to illustrate the potential upside as well as to ensure the company isn’t giving away more than necessary.
Valuable data at your fingertips
While it is important to build and maintain up-to-date cap tables, if built robustly, these can be valuable tools in making capital structure decisions for the business. In addition to illustrating proposed or projected transactions, such as additional financing rounds, IPOs and exit sales, business owners can quickly run scenarios that reflect various dates, valuations and funding amounts.
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Hylton Levy is a Partner with the Restructuring practice of Farber. His practice focuses on corporate restructuring and insolvency solutions, distressed financial advisory services and corporate consulting advisory services. Hylton can be reached at 416.496.3070 and email@example.com.
Adam W. Silver is a Managing Director of the Performance Acceleration practice at Farber. The Performance Acceleration practice helps executives and boards overcome operational and strategic challenges to uncover potential and unleash performance. Adam can be reached at 416.496.3734 and firstname.lastname@example.org.