In this first article, Karen Kimel will explain the importance of capitalization tables—along with the fundamentals for preparing cap tables. Part two will look at funding rounds and structuring cap models with the flexibility to allow investors and businesses to understand the impact of raises and returns on capital.
Start-ups and rapidly growing companies can be absolute whirlwinds. Between refining your product or service offerings, hiring and managing employees, paying the bills while also steering your strategy—business owners are being simultaneously pulled in multiple directions. However, when it comes to your investors and equity capitalization, is enough being done? Do you have a clear snapshot of all your investors? Do you know who owns what and who actually controls the vote on critical decisions? On the flip side, if a potential investor came along, would you be able to provide them with an up-to-date glimpse of current state of affairs?
If you’re struggling to answer these questions, a capitalization table (cap table) may be just what you need.
So, what is a cap table?
A cap table is a table that shows the equity capitalization for a company. It should include all forms of equity, such as common and preferred shares or dilutive equity instruments such as warrants, options and convertible debt. These dilutive instruments should be included in the cap table regardless of whether they have been exercised, vested or converted.
Each stakeholder’s interest in the company will be included in the cap table and will provide that stakeholder’s individual valuation. A stakeholder’s valuation can be calculated in various ways, such as by multiplying the share price by the number of shares owned, or by determining the proportionate number of shares the investor holds of the company’s valuation.
The trend in cap table management
The number of enquiries and assignments our team receives for building cap table models has continued to grow. These requests often come from start-ups or high growth companies that are looking for additional equity investments and need to understand the impact and dilution of further equity funding on their existing investors. Cap tables are commonly used to determine how options can be used to incentivize and attract key talent.
What details should be captured in a cap table?
For each investment made in a company, the cap table should include:
- the name of the investors
- the amount contributed by each investor and the number of shares received for each round of funding the valuation
- options and other convertible instruments, exercise or strike price, vesting requirements, and valuation caps (in the case of warrants)
- convertible debts, including the terms of conversion
- the total share to be calculated on a current and fully diluted basis (which shows the percentage ownership of a company assuming all convertible instruments are converted to equity)
A well-managed cap table will be updated with any change in the capital structure of the company, including issuances or repurchase of capital, or vesting, exercise, granting or conversion of instruments.
Why are cap tables important to investors?
For investors considering an investment in a company, the cap table can be used to understand what share of the total pie they will get for their contribution as well as what their share looks like on a fully diluted basis. The investment made, and shares received, will result in an implied valuation of the business.
For those investors considering an additional investment, not only is it important to understand the new implied valuation they are buying into, but it’s also important to understand the impact non-participation will have on their proportionate share of the company. The risk in not participating in further rounds is the dilution to the investor’s proportionate share of the company. In the case of voting shares, dilution will reduce the investor’s ability to influence voting at shareholder meetings.
Understanding the impact of dilution
To calculate the impact of dilution, the cap table needs to consider:
- the effect of converting instruments, as well as the effect of any additional instruments that may be impacted by the conversions
- the order of conversion
- any exercise or strike prices
Here is a simplified example:
- a company is assumed to issue a founding round of capital raising $8 million and issuing eight million common shares
- the company has also granted 600,000 options with an exercise price of $0.67 per share
- the below cap table illustrates the impact of these options being exercised on the investors
- the dilution has reduced the value per share from $1.00 to $0.98 and has lowered the proportionate share each investor holds of the total issued shares
A Clear Snapshot
For both investors and companies to make the best decisions around its capital management, a cap table should be developed and updated on a regular basis. Not only will an up-to-date cap table provide companies, investors, and would-be investors a clear snapshot of equity capitalization; it will allow senior management to make the calculated and informed decisions needed to scale and take their business forward.
Recommended for you
How Funding Rounds Impact The Cap Table. Read Part Two.
Karen Kimel is a Managing Director with the Restructuring group, and she is the co-leader of the Business Modelling & Analytics team at Farber. Karen can be reached at 647.796.6022 and firstname.lastname@example.org.
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.