Cap table mistakes can be extremely costly for founders.
Every startup needs to build and maintain an accurate capitalization table, but that’s easier said than done over the long term. When your company is first starting out, your equity shares and ownership percentages are pretty straightforward. Most startups have somewhere between one and four co-founders, which makes the division of ownership easy to track.
But after your startup expands, hires a few employees and goes through a couple of rounds of funding, things get a bit murkier. Unless you keep a meticulous record of every transaction that impacts your company’s ownership changes, you’ll end up with nothing but headaches. Fortunately, we’ve put together this guide to help you avoid the pitfalls that so many startup founders run into with their cap tables.
What are Capitalization Tables?
Capitalization tables are a theoretically simple tool that startups use to keep track of company structure, ownership and share value. It should include each equity holder’s:
- Basic information: Name and contact info
- Ownership details: Number of shares, ownership percentage
- General transaction details: Date of issuance, exercise dates and vesting schedules
A basic capitalization table may only include the initial founders’ contributions and ownership percentages, but even at that stage, it’s an important document to have. The last thing you want to do is create conflict between founders down the line due to a miscommunication over ownership or profits.
When your startup becomes more complex and issues employee stock options or warrants, your table will also have to expand to include the additional complications.
Capitalization Table Benefits
Keeping an accurate capitalization table may not seem like a particularly pressing issue, but it becomes critical when you have to deal with one of the following:
- Rounds of Funding: Potential investors will need to see an up-to-date capitalization table when they’re considering whether or not to invest their capital in your startup. By studying your cap table, they’ll be able to gain an accurate understanding of your private company’s fair market value (FMV) and what they’d get in return for their investment. It’ll also help you to know exactly what you’re giving up, which should always be a consideration when you’re taking on investors.
- Tax Compliance: An accurate capitalization table is also necessary to properly report your share of your business’s activities each tax year. If your details are inconsistent and one or more of your founders report contradictory information, you may end up facing an audit. If that happens, you can be sure the IRS representative will be taking a hard look at your cap table to assess what happened.
- Exit Strategies: When one or all of your startup’s owners decide to sell their shares, you’ll need to have an accurate record of their ownership and profit percentages. An accurate capitalization table is the only way to make sure that you properly execute the transition between the previous and new owners.
Most Common Capitalization Table Mistakes
1. Inconsistent information
As your capitalization table becomes more and more complex, it will become increasingly difficult to keep track of additional transactions.
Over time, you may find that the dates of various transactions don’t agree, there are multiple names for the same shareholder or entity, or that your share allocations are no longer inaccurate.
The longer this goes on, the more difficult it becomes to backtrack and unwind past mistakes. Eventually, the damage may become irreparable.
To minimize this as much as possible, you’ll want to make sure that you use only legal names and official titles and implement a regular system for confirming the accuracy of your cap table.
2. Not Properly Tracking Complex Transactions
Your capitalization table is a document that will be in flux consistently, especially once you begin to issue stock options to your employees.
And since equity compensation has become such an extremely popular form of payment for cash-strapped startups, you may not be able to avoid it.
Unfortunately, that also means you’ll need to keep track of your stock option issue dates, any invalid equities due to employee turnover and each employee’s exercise dates. Failure to do so could land both you and your employees in tax trouble, at the very least.
Whenever an employee joins or leaves your team, update your capitalization table to prevent employees from exercising their options outside of the permitted window.
3. Not Updating the Table on a Timely Schedule
With any form of financial documentation, you’re increasingly likely to be inaccurate the bigger the gap is between when events occur and when you update the record.
Capitalization tables are no exception. And unfortunately, it can be especially easy to let cap tables fall to the wayside because there are so many more pressing matters that demand your attention.
Even financial statements get used (and therefore updated) more frequently since you’ll need them for all sorts of financial planning and forecasting.
But even though your cap table is used less frequently than your balance sheet, it’s just as important to potential investors during rounds of funding.
4. Maintaining Records by Hand
In the modern world, there’s little reason to do much of anything by hand anymore. Old-fashioned methods take so much more of your valuable time that it almost always works out in your favor to pay for the added convenience and efficiency.
Capitalization tables can be demanding, especially once your company evolves past the bootstrapping stage. Maintaining your records by hand puts you at risk of unnecessary human error, even if you’re well-researched and fully conscious of all the rules you need to abide by.
But with the proper software, you can leave complex spreadsheets behind, update your cap tables automatically and record transactions as accurately as possible.
5. Misunderstanding Related Legal or Tax Rules
The number of implications of each equity transaction can be intimidating, and keeping up with all of the repercussions can quickly become a full-time job.
When it comes to something as critical as capitalization tables, the stakes for your business are too high to go it alone. You don’t know what you don’t know, and that can quickly become catastrophic for your startup.
An inaccurate cap table can put your company at risk of losing valuable investors, facing lawsuits and getting in trouble with the IRS.
How to Avoid These Mistakes
While managing your own cap table is certainly doable, it’s very likely to be more work than is justifiable for you to take care of in-house. Fortunately, professional services like lawyers and accountants exist to help with exactly these sorts of complications.
They’re usually better equipped technologically to handle the problem and almost always have more relevant experience. These two factors usually make outsourcing a cheaper and more effective option. Using professional accounting services can help you avoid just about all of the above potential pitfalls pretty easily, too.
To get the most out of your accountant, you should engage a firm that understands the nuances of startups. If your startup is currently looking to outsource the management of its capitalization table, Founders CPA can help.
We have extensive expertise with cap tables and other startup tax issues, and we’ve helped hundreds of companies like yours navigate them.
Take advantage of our free consultation today to learn about all the problems that we can take off of your hands.