How To Read a Cap Table

Setting up a cap table is one of the first things start-up companies must do as they prepare to raise capital. Because start-up companies are private, investors don’t get the same level of transparency for a business’s financials as with a public company. The cap table is, therefore, an essential resource. This article will go over what a cap table represents, its different elements and how to read a cap table.  

What is a Cap Table?

A capitalization table, AKA a cap table, is a spreadsheet document that private companies use to track their securities, the equity ownership of all shareholders and the value of the equity. Several types of information are typically included: 

• Common shares 
• Preferred shares 
• Convertible notes and warrants (and who owns them) 
• Prices paid by investors for securities‌ 
• Valuations 

Investors must understand how to read a cap table to ensure it accurately reflects their ownership share of a company. That way, you can detect any discrepancies and notify the company to request corrections in a timely fashion. 

The cap table is typically the first document that a start-up has to create. Once a start-up undergoes a few rounds of financing, the details of the cap table can grow in complexity and include additional information and transactions like: 

• A large list of shareholders 
• Option & equity plans 
• Exercised options 

Cap tables also reference other legal documents outlining events that happened since the creation of the company, including: 

• Stock issuances 
• Transfers 
• Cancellations 
• Conversion of debt to equity‌ 

How are Cap Tables Used?

Venture capitalists, investment analysts and entrepreneurs, use cap tables to go over significant events in a company’s history, like the issue of new securities, ownership dilution and employee stock options. Pre-IPO companies leverage cap tables in the following ways: 

To Raise Funds 

When start-ups begin to negotiate with potential investors, they typically want details about who owns the company and changes since the last round of funding. As an investor, you should look to cap tables for answers to questions you have about a company’s potential, including whether they’re facing any potential legal issues and where they rank if the business is liquidated. Ideally, you want to be as close to the top as possible to be in a better position to recoup your investment. 

To Comply with Tax Requirements and Other Regulations

Cap tables are considered to be a formal legal record of equity ownership in the United States. They’re what tax authorities refer to when assessing whether or not a business, along with employees and investors, has paid what it owes in taxes. So if you decide to invest, you want to make sure the company is regularly updating its cap tables so that you don’t end up with an unexpected bill for other people’s mistakes. ‌‌ 

To See the Impacts of Various Decisions

Cap tables allow pre-IPO companies to look at how different business choices would affect the company’s equity structure. As a shareholder, you can also view the impacts and understand what you have to gain or lose if company owners follow through with a decision. This can be a critical part of fundraising and software can greatly help in this analysis.   

 

What Are the Key Terms Used in a Cap Table? 

If you’re going to become a successful investor, you must have a solid understanding of the standard terms used in cap tables. The following key terms are often used in cap tables.  

Debt

This is money borrowed by a company that must be repaid with interest. 

Equity

This is a stakeholder’s share of capital in a company. Owners of the share gain a controlling interest in the company and benefit from positive financial outcomes. 

Common Stock

Each share of common stock you purchase gives you partial ownership in a company. As a shareholder, you gain certain rights regarding company profits and a say in how the business handles matters that affect its bottom line. 

Preferred Stock

Preferred stock is a group or series of stocks that confer special rights and privileges. Investors owning preferred stock have priority over investors holding common stock. 

Stock Options

Stock options  provide you with the right to buy a specific number of shares at a set price during a certain period. They are typically issued according to the terms outlined in a stock option plan from a preapproved share pool set aside for that purpose. 

Warrants

Warrants are similar to stock options in that they represent a contractual right to purchase stock at a later date. However, while stock options are issued via a stock option plan, warrants are typically one-offs and are not included in a stock option plan. 

Option Pool

Option pools are a set number of shares put aside for allocation to senior management and employees. 

Pre-Money Valuation

This outlines the value of a company before equity investments. The pre-money valuation is decided through negotiations between company owners, new investors and existing investors. 

Post-Money Valuation

This outlines the value of a company after equity investments. You calculate post-money valuation by adding the value of the pre-money valuation to the total equity cash received.  

Authorized Shares 

This refers to the number of shares authorized by a company for current or future issues. 

Outstanding Shares

This refers to the number of shares already issued minus ungranted options. Outstanding shares exclude granted options not exercised. 

Fully Diluted Shares

This is a single number representing what the number of shares would be if shareholders executed all outstanding contingencies. It includes all granted options, restricted stock, warrants and the remaining option pool. 

Price Per Share

This is a calculation for which the post-money valuation is divided by the total number of fully diluted shares available. 

Convertible Debt

This is debt finance that can be converted into equity in the future. Convertible debt has clear parameters outlined regarding when it’s eligible for conversion into equity. In addition, convertible debt can accrue interest until the conversion occurs.‌ 

Pre-IPO companies often use convertible debt to sidestep questions regarding valuation from initial investors. As you consider investment options, keep in mind that failing to acquire a valuation can lead to problems down the line. 

Convertible Note

This is a special kind of debt that is not intended for repayment in cash. Convertible notes are designed for conversion into company shares in the future. You should pay special attention to investors holding convertible notes and how they rank. They’re the ones who are first in line for repayment if the company ends up in a liquidation situation. You always need to know the following: 

• The debt that a company currently owes 
• How much of it is convertible 
• The terms of the conversion‌ 

Each of the above factors plays a role in how much of your investment you are able to recoup. Watch out for details like these: 

• What date the company incurred the debt 
• The interest rate on the debt 
• How the interest rate gets calculated (annually, semi-annually, cumulatively, etc.) 
• When the debt is due 
• The terms and conditions of any conversion‌ 

How Do Cap Tables Change?

Cap tables usually remain relatively simple during a company’s seed stage of funding. For example, if there are only three owners, the cap table reflects the division of shares. This changes after a company bring in new executives, investors and potential creditors. 

Businesses often recruit top executives and personnel by providing them with benefits packages that include options and warrants. These are typically pulled from an option pool, which can vary in size. Option pools can sometimes represent up to 25% of a business’s outstanding shares.‌ 

Events that can result in changes to a cap table include: 

• The creation of an option pool. 
• Someone exercising their options or warrants. 
• Any transfer of shares from an owner to a different entity, such as another investor. 
• The departure of an employee from the company, resulting in the termination of any unused options, share awards, or expired warrants.‌ 

Capital funding can emerge from various sources during the early life of start-up, including from family, angel investors and venture capitalists. Any capital raised can become equity or debt, both of which should be recorded in a cap table. You might see a new column in the cap table if, for example: 

• Shares of new or existing security are sold 
• Convertible debt is issued through a note 
• Warrants are issued during a debt or equity round of financing‌ 

Understanding Waterfall Analysis

The term “waterfall analysis” refers to the process for calculating, based on available funds, money payable to the shareholders listed in a cap table if a business is liquidated. The events that can lead to liquidation are often fluid.

With waterfall analysis, you’re relying on various assumptions to establish a specific percentage of funding payable to shareholders in the case of company liquidation. In addition, during the sequence of calculations involved in waterfall analysis, you apply different investment decisions, like anti-dilution provisions and liquidation preferences, into a cap table in the order required to make them “flow” through to the end. Because of the complexity involved in waterfall analysis, many potential investors rely on cap table software to model various scenarios.

Building Your Cap Table

Many CEOs and CFOs might start using excel but this can become labor intensive, error prone and does not look good to potential investors. Diligent Equity offers simple and easy-to-use software to solve these issues and you can sign up for a free trial here!