I have had numerous discussions with startup founders about the forming their companies, fundraising, finding strategic partners, and cap tables. I discovered that like many entrepreneurs, founders know the basics about cap tables but not nearly enough. So I thought for the benefit of the team I’d put together a quick memo about the ins and outs of cap table construction. So here are a few key cap table concepts that will help you navigate the journey from inception to exit.
So what is cap table management, anyway? If you’re an entrepreneur, you may think you know everything there is to know about putting together a cap table for your company. To put together your cap table, you’ll probably think of a simple excel spreadsheet. But, this is generally just the tip of the iceberg. The “cap table” that most people think of is merely a representation of all the transactions that have taken place since the company’s inception. In reality, a cap table is made up of many transactions and legal documents—stock issuances, sales, transfers, cancellations, conversions of debt to equity, and exercises of options, to name a few. It gets pretty complicated.
Cap table management is accurately and effectively managing these complexities. This includes drafting and signing legal documents, recording transactions, communicating with shareholders and complying with regulations among other things.
If you haven’t encountered the complexities of cap tables yet, hopefully you will. Virtually any company that turns out to be worth something will naturally progress into a fairly complex capitalization structure.
You’ll have several investors who helped you along the way and some rock star employees who joined hoping to receive a valuable piece of equity. These are all good things, but they add some administrative burden to the already-stressful job of growing your company.
Why does cap table management matter?
Modeling new rounds of financing and analyzing the impact on shareholders will be key to negotiate with investors and maintain a meaningful stake for founders and employees. Your cap table will be at the center of these negotiations, so having everything up to date and accurate is crucial.
Recently, we had a company come to us while they tried to raise money. They found an interested investor, but the investor wanted to see the cap table before kicking things off. They contacted us on a Thursday and asked if we would help them organize their cap table from the dozen or so excel files and PDFs they had been using, because the investor wanted to talk on Monday.
After some late nights and a lot of scrambling, we were able to piece together an accurate cap table for them to use in the negotiations. With a clear picture of the situation, we were able to use Capshare to help them analyze different term sheets and model the future economics of the cap table. They successfully closed the round and ended up with a much better deal than they would have had without the organization and insight gained from the cap table.
The point of this story is that you don’t want to wait until the last minute to start mapping out your cap-table, corporate structure, and exit strategy. Luckily, we were able to hustle and make it happen, but that’s not the ideal situation. If you have an organized cap table from the start, you’re much less likely to make costly mistakes when it comes time to raise capital.
Options to buy stock typically vest over time, so you need to keep track of how many shares have vested for every option grant. If an option holder leaves the company, their unvested options are forfeited, and they have a set amount of time to exercise any vested options before they are also forfeited. You also need to keep track of early exercises, restricted stock, transfers and repurchases.
As you can see, issuing options to employees makes cap table management significantly more complex. Plus, all your option activity will need to be accounted for on your financial statements under ASC 718 stock expense requirements. This is a pretty complex task by itself, although we’ve worked hard on a solution to make it easier.
Hiring Key Employees
Equity is a big component to hire and retain key employees at startups, so the ability to accurately layout a compensation package is critical. Recipients of equity, particularly executives, will want an idea of the payout at various exit values if the company sells.
More and more companies are choosing to be transparent about the cap table with all employees—not just investors and executives—which means you might have to field questions and inquiries for information in order to retain employees and keep them motivated. This doesn’t have to be a bad thing. Companies who are honest and organized have a better chance of keeping morale up even during the hard times. If you have the right info and the right tools, your cap table can be a great asset from a human resources standpoint.
A major part of cap table management is tax and regulation compliance. The IRS has a lot to say when it comes to the taxation of equity, so you need to make sure you’re doing things right. If you do it wrong, you or your employees could end up paying tax penalties or paying more taxes than you need to.
For example, if you want to give employees the best opportunity for favorable tax treatment, you’ll want to make options early exercisable. This allows them to exercise unvested options into restricted stock so they can start the capital gains clock (you have to own stock for at least a year in order receive capital gains treatment).
Here’s a list of the most common regulations in the US:
- ISO $100K limits stipulate how many options can vest in a given calendar year in order to qualify for certain tax treatment.
- IRC 409A regulations require you to do a formal valuation at least once a year to determine an appropriate strike price for options. Checkout the 409A Guide and Infographic to learn more about these requirements.
- ASC 718 (formerly FAS 123R) is an accounting requirement for measuring and recording the expense associated with issuing equity-based compensation. We’ve put together a basic explanation of stock expensing if you want to learn more.
- Rule 701 is an exemption from being required to register with the SEC in order to issue equity compensation.
- 83(B) election pertains to the tax treatment of restricted stock awards, and it needs to be filed within 30 days of the grant.
We can’t cover all the taxes and regulations here, but just be aware that this is a very important component of cap table management.
Selling the Company
When it comes time to sell the company or go public, your cap table spells out who gets what. If you get acquired, a team of lawyers will pour over every detail of your cap table. But they’re not going to rely on the spreadsheet you’re maintaining to determine cash distributions. They’re going to look at shareholder agreements, option agreements, sale agreements and so on.
If all this information is stored in disparate and conflicting records, there will be extra work to determine the correct ownership. Erroneous or incomplete information could result in legal disputes. And when you’re trying to sell the company, the last thing you want is a lawsuit or a lengthy due-diligence exercise.
How Do I Manage My Cap Table?
You can stay on top of everything and avoid costly mistakes by implementing a few best practices. This isn’t a comprehensive checklist, but it should help you address the most important areas.
Record Basic Share Counts
Most people start managing their cap table in a spreadsheet. It’s an easy way to record basic info like who the shareholders are, how many shares they have, and what percentage of the company they own. This is the bare minimum, but it gets old fast. You’re better off using an online platform to make things easier.
Start a Central Repository
You’ll also need to keep track of legal documents, and at some point, you will likely start recording shareholder transactions and reporting to investors. Establishing a central repository for all this information helps avoid conflicting records and makes it easy for everyone to access information when needed.
Keep Up on Compliance
Compliance is pretty straightforward in the early stages, but more and more regulations arise as your company matures. You want everything on your cap table to be legally correct and verifiable. A few consultations from a good attorney goes a long way here, so don’t be afraid to seek counsel.
Keep Everyone On the Same Page
Along with keeping all your information centralized, make sure that everyone involved agrees on the accuracy of this information, and that they are informed of changes to the cap table. You’ll end up with angry shareholders and investors if they’ve made decisions based on incorrect or out-of-date information, so make sure all parties are in the know.
At the end of the day, cap table management is all about legal claims to the assets of the company, so you don’t want to take shortcuts. It’s pretty straightforward when you start out, but things can get complicated quickly. The good news is that you can generally learn as you go, and as long as you have the right tools and information, you can stay on top of things and make smart decisions with your cap table.
If you walk away with nothing else, just recognize that your cap table is extremely important. Founders and startup employees have a lot at stake when it comes to their equity, so take the time to understand the legalities and the economics of your cap table. Next to building a great company, your cap table might be the most significant contributing factor in the creation of wealth for entrepreneurs.
Image credit: CC by Indraneel