When you first started your company, you may have envisioned always having sole ownership of the enterprise. While that may be an admirable goal, it’s not the case for the vast majority of startups.
Typically, as an organization grows, its ownership also shifts. That’s due to a number of factors, most notably funding rounds that result in new equity partners entering the business.
As the makeup of company ownership shifts and changes, you need to keep track of who has what, and what that means for the business. That’s where a capitalization table comes in. This crucial document is a snapshot of who has what piece of the company and under what terms.
The implications for your organization are huge. Many big decisions affect ownership, so knowing those potential ramifications ahead of time is essential to sound policy-making.
Despite its importance, the cap table does not have to be complicated. Here’s what you need to include and how to make it accurate and functional.
Capitalization Table: Definition
In its most simple form, the capitalization table is a simple list of who has put what into the company and the corresponding ownership percentage.
For example, in advance of a Series A funding round, founders may own 100 percent of the company. If the pre-funding valuation is $1,000,000, then two founders may have an equal ownership stake of 50 percent each.
A funding round may bring more money into the company. But it also brings in more equity partners, who each now own part of the business. The total raised may bring the valuation up by an amount equal to that influx of capital. In the process, the business may be worth more on paper — but the original founders own a smaller slice than they did at inception.
If two investors contribute $500,000 each, the new money brings the company’s total valuation to $2,000,000. The original founders now own 50 percent, or 25 percent each. The new investors also each own 25 percent of the company with the $2,000,000 valuation.
The capitalization table shows this shift. One section called “Company Valuation” will show the pre-funding valuation and post-money valuation. The following section is a detailed list of each of the investors, their respective capital contributions, the amount of preferred or common shares each owns, and the percent ownership.
How It Changes Over Time
Clearly, the capitalization table can quickly become a living document. That’s because in the life of a business, many things can happen — and companies take on investment under different terms. They may also want to offer share options to current or future employees.
In other words, things can shift quickly. In order to be accurate, the capitalization table takes into account not only what has happened, but what might happen. Therefore, things like convertible debt, warrants, options, and convertible notes are calculated on the table as if they were fully exercised.
That means ownership stakes are immediately diluted according to the agreements that have been, or will be, made. As a company grows in size, the number of transactions that may impact the capitalization table can become quite large. Staying organized and up-to-date is crucial since the value of the company relies on the accuracy and completeness of this table.
Thankfully, companies don’t have to undertake this essential task without professional assistance. This is one time where working with an expert is an important way to prevent mistakes that cost the business. As a new founder or leader in a startup, consider working with Founder’s CPA on establishing your capitalization table and ensuring it stays up to date with each transaction.
Using the Cap Table to Make Decisions
It may sound like the capitalization table is a kind of hidden record that you might simply shelve when not in use. But it is actually much more than that. It is a document to which you should refer before extending too many promises to key members of your organization.
Your capitalization table demonstrates how much of the company you can afford to give away in terms of options to new employees or partners. In the early days of startups, many founders work on sweat and faith — and options may be a way of getting others to join with them in the vision. While this is important, it’s essential to know ahead of time what percentage you can afford to give away.
A capitalization table may include an option pool, for example, where shares are set aside just for these incentive programs. Since a capitalization table assumes all options are already exercised, this pool should already be reflected in corresponding ownership stakes, where those rates are already diluted.
The capitalization table also distinguishes between who has common shares and who has preferred shares. Although common shares come with voting rights and preferred shares do not, in some instances both pools of shareholders must agree. Virtually any large-scale decision you have to make about your company depends on how it affects these ownership groups.
Your snapshot of ownership at any given time tells you the steps you need to take before arriving at any key decision. In essence, it tells you who has control over the company, and under what terms.
Tips for Effective Cap Table Management
To get your capitalization table right, you can take several important steps. The first is to work with an accounting firm and lawyer to discuss how you want to issue shares and under what terms. Since creating an option pool will happen at some point, it’s good to decide early what percentage you want to make available to key stakeholders.
Second, automate and centralize your data. There should never be an incident where failure to update has resulted in an out-of-date table. This can spell serious consequences for individuals and the company as a whole. Your systems should be functioning well, and you should appoint specific people to deal with the table.
Questions about your startup’s accounting? The team at Founder’s CPA are your partners in growth. Speak to us today about how best to build your enterprise.