How to read a cap table? Since it is not always easy to keep track of who owns what percentage of the business and even the total equity that has already been issued, it is important to have a document that records all the shares and shareholders of the company.
Instead of leaving your business’s shareholders guessing about the equity situation in your startup, it is important to provide a clear record of the ownership. Now whether you are an investor trying to invest in a startup, or an entrepreneur seeking equity-based investment, it is essential for you to familiarize yourself with the cap table.
So if you have been wondering how to read a cap table and understand it, then keep reading.
The Ultimate Guide To Pitch Decks
What exactly is a cap table?
Before we move on to how you can read a cap table, it is important to understand what the document is. A capitalization table also called a cap table, is a spreadsheet that private companies use to keep track of their securities, how much equity each shareholder owns, and how much the equity is worth.
The capitalization table lists all of the company’s securities, like common shares, preferred shares, and warrants, as well as who owns them and how much different investors paid for the said securities.
This spreadsheet can also be used as a reference by investors to know how much their shares are worth, and how their ownership has changed over time. In the early stages of a new business or startup, the cap table is normally one of the very first documents that a startup creates, because it is actively seeking investment during these initial stages.
After a few rounds of financing, the cap tables get more complicated and list possible sources of funding, IPOs, mergers and acquisitions, and other transactions. A cap table is important for not only the investors but for the founders as well.
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How does a cap table work for the startup and its founders?
As mentioned earlier, a cap table is not just meant to be used by the investors, but it can also be used by startup founders for various reasons. So, without further ado, here are some key applications of a cap table for founders:
Helps attract investors:
When new businesses start talking to potential investors, they usually want to know who owns the business and what has changed since the startup raised the last round of funding. As an investor, you should look at cap tables to find answers to questions you have about a company’s potential, such as if it has any legal problems or where they stand if the business gets closed down. Investors ideally want to be as close to the top as possible so that they have a better chance of getting their money back in case things go south with the startup, and a cap table provides all these details to investors.
See How I Can Help You With Your Fundraising Efforts
See How I Can Help You With Your Fundraising Efforts
Helps fulfill tax requirements and other rules:
In the United States, cap tables are a formal legal record of who owns what shares of a company. They’re what tax authorities use to figure out if a business, its employees, and its investors have paid all the taxes they owe. So, before investors can invest in your startup, they will need to make sure the company keeps its cap tables up to date, so they don’t have to pay for any mistakes made by founders.
Testing the impacts of the business decisions
Companies that are getting ready to go public can use cap tables to see how different business decisions would affect the equity structure of the company. Shareholders can also see how a decision will affect them and what they might gain or lose if the company owners go through with it.
Helps in running the business better:
The founders can make sure the right investors are kept in the loop if they have a full list of all their investors and how much they own. The cap table can also help with decisions like whether to offer new shares or stock options and the right time to offer them.
Take care of the pool of employee stock options:
A cap table is a good way to figure out how much money to put into the employee option pool. Without knowing how to read a cap table it is possible that you might end up issuing too many stock options to employees, which can dilute the value of the company’s stock.
Make sure that any audits or checks for compliance can go smoothly:
A well-kept cap table can be very important for audits and future rounds of funding.
How does a cap table work for investors?
As mentioned above, a cap table is mainly used by investors to understand the equity distribution of a startup. However, investors can use a cap table in a variety of other ways including:
Gives investors an insight into the startups’ ability to retain talent:
Stock options are a big incentive for employees to work for a startup. Investors probably want to see a large enough pool of employee stock options to attract, keep, and motivate the talent the startup needs to grow.
Allows investors to know more about other investors:
The names and percentages of ownership of the other investors on the cap table can make people feel good about the business because it shows that other investors already trust the startup enough to put their money in it. Investors also want to know how many other investors are investing in the startup. If there are too many, the founders may have to spend a lot of time getting everyone on the same page, which could make future negotiations harder.
Can help them figure out how much they want to invest:
Investors can figure out how much they should invest in a startup by looking at a startup’s cap table. Using the current value of the startup and an estimate of the startup’s exit value, investors can figure out the right amount to invest. There are many things that could change in the future, so investors shouldn’t solely rely on the cap table when investing in a startup. However, it still helps investors a lot before they put their money into a business.
Even as you’re reading up on how to understand a cap table, you might need more information on how to raise startup capital. Check out this video I have created where I explain how that works.
How to read a cap table?
Now that you know what a cap table is and how it works, it is time to answer the key question, that is, how to read a cap table. In order to read a cap table, you need to be familiar with the terms it may contain, so, without further ado, here are the key terms that are normally part of the table.
Debt is money that a company has borrowed and must pay back with interest over time. This helps investors to understand how much the startup owes to banks and other lenders.
Equity is an individual’s share of a company’s capital. The person who owns equity in the startup owns a portion of the business equal to the amount of equity they hold.
When you buy a share of common stock, you get a piece of the company. As a shareholder, you have a voting right if you hold common stock in the company, and you can vote on how the company handles things.
Preferred stock is a group or series of stocks that give their owners extra rights and benefits. People who own preferred stock come before people who own common stock.
These are a special type of stock offered to employees that gives them the right to buy a certain number of shares at a lower than market price within a certain time frame. They are usually given out based on the terms of a stock option plan from a pool of shares that have already been approved for that purpose.
Like stock options, a warrant is a contract that gives the holder the right to buy the stock at a later date. But stock options are usually given out through a stock option plan, while warrants are rarely offered by startups and are not part of a stock option plan.
An option pool is a group of shares that are set aside for senior management and employees. Any stock options that might be issued are supposed to be issued from this reserved pool.
Pre Money Valuation:
This shows how much a company is worth before investors put money into it. The pre-money valuation is decided by negotiations between the owners of the company, new investors, and current investors.
Post Money Valuation:
This shows how much a company is worth after investors have put money into it. To figure out the post-money valuation, you add the value of the pre-money valuation to the total cash received during a funding round.
This is the number of shares that a company is allowed to give out now or in the future. The number of authorized shares can also be changed by the consent of the shareholders of a company.
This is the number of shares that have already been issued to investors. Outstanding shares are meant to be issued from the authorized share pool, and each share issued to the investors adds to the outstanding shares count.
Fully Diluted Shares:
Fully diluted shares show how many shares there would be if all outstanding shares, stock options, convertible securities, and other reserved stock are exercised by the holders. It also considers all options, restricted stock, warrants, and the option pool that hasn’t been used yet and is still in the reserved state, ready to be issued.
Convertible debt is debt financing that can be turned into equity at a later date. Convertible debt has clear rules about what conditions need to be met in order to turn the debt into equity. Also, until the debt is converted into equity the interest can be added to the total convertible debt.
This is a special type of debt that is not meant to be paid back in cash. The idea behind convertible notes is that they can be turned into company shares in the future. When you’re learning how to read the cap table, pay close attention to the investors who hold convertible notes and what ranks they hold in the investment hierarchy.
Now, remember that if you are a startup founder that is trying to form your very first cap table, it might not be easy to get all these terms right. So it is best to have a legal expert on your team when creating a cap table for your startup.
So there you have it, a cap table might have seemed like a complex matter when you didn’t know anything about it, but now that you have read this article, the cap table doesn’t have to be that complex.
By understanding what a cap table is and how it benefits both the founders and investors, you can now learn how to read a cap table and optimize it for success.
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