Capitalization tables (Cap tables) are among the most important documents every entrepreneur should understand. This misleadingly simple document, which looks like a standard spreadsheet, lays out who the stakeholders are in a company and how many shares each person owns.
However, this simplification does not do justice to the complexity that cap table management entails. As a company grows, more people will jump on board and the ownership will get increasingly complex. Each new investor and significant employee will want a piece of the upside - i.e. to get on your cap table.
Investors will want to understand who is already on your cap table, and more importantly, you will want to know how your ownership will be affected by the new sailor that just jumped aboard. This story - and more -- is all told by your cap table. Besides this, your cap table includes drafting and signing legal documents; recording transactions; communicating with shareholders; and complying with regulations.
When I founded my company Fundacity, I encountered firsthand many of the expected pain points in using a simple DIY Excel sheet to manage our cap table. I had a co-founder, an option pool and three family, friends and fools (FFF) investors before raising our first seed financing from an early-stage fund.
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Using our amateur Excel sheet, it was challenging to negotiate the investment and fully understand the dilutive effect of the new financing round on existing shareholders. We were essentially flying blind into the negotiation. Fixing our broken cap table cost us $5,000 in legal fees - not to mention the stress of reconstructing past transactions in order to rebuild the integrity of the cap table.
Unfortunately, we continued to maintain our cap table internally, and when it came time to sell Fundacity, neither us nor the opposing counsel, relied on our Excel sheet, and a new audit was required.
This time the fees were much steeper. Both parties had to look at every shareholder agreement, option agreement and convertible note. It created additional work, costs and stress at a time when we could least afford it. The lesson was clear: when it comes time for another fundraising round or exit, the last thing anyone wants is a lawsuit or a lengthy exercise in due diligence.
These 12 rules will save founders from costly mistakes during hiring, fundraising and acquisitions.
- Incorporate your startup in the appropriate jurisdiction.
- Create an Equity Incentive Plan to compensate your advisors, employees and partners with the most valuable asset that you hold - your equity.
- Pick an easy to use participatory platform that allows you to collaborate with a counterparty to verify every transaction. Cap table errors are a natural side effect of a manually recorded ledger without counterparty verification. Every stock certificate, option grant, exercise, transfer or convertible note issue is a transaction that updates the cap table.
- Record convertible notes. Convertible notes are rarely recorded in a cap table, but staying on top of this will save you time, expenses and unpleasant surprises when you raise a conversion triggering equity round.
- Keep track of stock options and vesting schedules. Typically, options to buy stock will vest over time, so you need to keep track of how many shares have vested for every option grant. Company employees and your fellow founders will be grateful to have clarity over this.
- Record basic share information such as who the shareholders are, how many shares they have and what percentage of the company they own.
- Start a central repository. Having a central repository for legal documents and shareholder reporting helps avoid lost documents, conflicting records and makes it easy for everyone to access information when needed. During a legal due diligence process this can save you days of work and stress.
- Keep everyone on the same page by sharing your cap table regularly. Specifically make sure that the relevant parties agree on the accuracy of this information, and that they are able to see an audit log of all changes to the cap table. The last thing you need is an internal dispute during a financing event.
- Don’t overcomplicate your cap table. It should be easy to read and understand with supporting documents and commentary where necessary to make the information self-explanatory.
- Don’t turn the responsibility for maintaining the cap table over to someone without clearly defining this role. Ultimately, the founder is responsible for all aspects of the business.
- Never lose track of your shareholders’ information. Make it is clear to investors and employees that they must inform you of a change of address. Losing information can cause major delays in a merger or IPO situation and could jeopardize the deal entirely.
- Lastly, don't succumb to creating an inaccurate cap table with the intention of fixing it later. The problems will only compound, and fixing it later will be much more costly and difficult to manage.
An entrepreneur, who can stay on top of these 12 rules, will be well positioned throughout negotiations, and stakeholders can rest assured their shares are being accurately managed. While it may seem overwhelming, the good news is that there are platforms out there, like Gust Equity Management, which can help you easily build and accurately keep track of your cap table.
It’s important not to let your cap table run out of control and become a roadblock for you to close a deal in the future. Equally, don’t let cap table management be a complex daily task. Find a process that works for you and is easy to manage so you can focus on what matters most - building and scaling your business.