II.The capitalization table
A startup’s capitalization table (or cap table) is something you want to get right from day one. It’s also one of the topics that we encourage founders to spend some time with – whereas almost everything else related to a startup is relatively changeable, if the ownership structure is set up badly it can be a major problem. In the worst-case scenario, it can dilute key people, diminish their future earnings and have an impact on whether your company is attractive to investors or not.
In short, the cap table is a list of all company shareholders, the number of shares, share classes and the percentage of shares they hold. To get fully-diluted equity ownership for each shareholder, you will also need to include the option pool you have allocated for key hires and calculate any possible convertible loans you have given out (more on what this means later).
For example, let’s assume a company has five founders. Two of them own 25.00% of the company and the three remaining founders own 15.00%. Usually, the founder-CEO is a majority shareholder, alongside one or two other key players. Other founders may have joined after the majority shareholders have already come up with and worked on the business idea, built the product and perhaps own the potential intellectual property (IP). 5.00% is reserved for future key employees’ options (we’ll discuss more about this later). The total number of shares is chosen relatively arbitrarily, but a good rule of thumb is to choose a number divisible by the number of founders (in this case: 200,000 shares, which is divisible by five). If the number of founders is still up in the air it can be a good idea to choose a number divisible by 60, so that it can be divided equally among one to six founders.
There is no absolute right or wrong way to split the ownership between founders. It should reflect how much the founders “bring to the table” so to say. For example, how experienced each founder is and who joined at which point are legitimate arguments for not splitting the ownership evenly. In some cases splitting the ownership can be the the most straightforward solution.
In the example above, a new investor is going to invest €500,000 into the company. The investment required is usually based on the founders’ estimate on how much money they will need in the next 18 to 24 months for sales, R&D and general administration. Injection of equity usually means the creation of new shares – the share price is based on the company’s valuation.
Why the cap table exists
Often the stakeholders who are most strict with cap tables are venture capital investors, also known as VCs (we will discuss more about VCs in the next chapter). The primary reason VCs are looking at the cap table is to see whether the operational founders are properly incentivized and committed to the company, meaning that they should own at least 50% of the total equity when in the scaling phase of the company. Founders who own stock even though they are no longer working for the company, advisors with relatively big chunks of ownership or long lists of business angels that significantly dilute the founder ownership are usually topics the VCs want to discuss and understand the circumstances behind. VCs prefer tightly-held businesses with “clean” cap tables, as they ensure closer relationships with other investors, smooth communication and easier vote collection in comparison to ones with a more complex ownership structure.
Even though it’s often VCs who raise concerns about the cab table being filled with many stakeholders, it’s not something that they as investors prefer from an admin point of view. It can cause many challenges if you have people in the cap table that don’t bring value to the company and can also be unfair for you as an entrepreneur from a financial point of view.
In the cap table, shares are classified as common stock or preferred stock. Common stock is “regular” stock and preferred stock gives the rights that are agreed upon in the Shareholders’ Agreement. These rights can include things like the majority of the preferred stock shareholders need to approve certain company decisions including large investments or divestments, selling part of or the whole company, divesting businesses, liquidation preferences, etc.
The option pool
The option pool refers to the Employee Stock Option Plan (ESOP), the legal framework for giving options to employees, which also lays out the standard terms and provisions for stock option grants by the company. An ESOP is a great tool for enticing and incentivizing high-caliber people to join a startup, most often in the crucial company scaling phase. How the stock options are treated and taxed varies greatly between countries, but they are usually subject to vesting – a predetermined period the employee needs to stay on payroll before the options can be sold, transferred or exercised. If you are employed at a startup or are thinking about it, you should ask about the criteria for the ESOP.
Employee stock options are a way to get employees interested in the growth of the company, as owning just a small portion of a widely successful venture can have a big effect (for example, the early team members of Supercell are all quite wealthy individuals nowadays). So while the founders own more shares, it can also pay off to work at a startup in its early days. Index ventures has created a great tool for assessing what size the employee stock option plan should be – there is a lot of variation depending on your home market, what the salary levels are and what stage you are in as a company.
When making an investment in an early-stage company, the VC often requests the creation of an ESOP. But we actually encourage you to have an ESOP before a VC demands it, or at least be aware that in the future you might need one.
There are often convertible notes listed in the cap table. The use of convertible notes and how they are treated in terms of taxation vary greatly depending on local laws. A convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. Founders may benefit from postponing the setting of company valuation, and the legal paperwork related to financing is much quicker. Convertible notes often come with a valuation cap, hedging the share price of the subsequent valuation round. Another way to hedge the risk of price increase is to agree on a future price discount and/or interest on the loan.
Due to the pricing uncertainty, convertible notes can place the VCs, founders and other investors on different sides of the table. The worst scenario would be a company initially having multiple convertible notes with different terms and an investor coming in with an equity investment – and all of them having contradictory objectives with regards to the company valuation.
Convertible notes are a useful tool for bridge funding in between rounds from existing investors to lengthen the company’s runway when it’s clear that the company is about to achieve milestones that have a positive effect on the value. VCs prefer equity in the initial investment round. The assumption is that a VC can and wants to define a valuation and the contract templates are also ready that keeps the costs low. The terms are also clear to both parties so there should be no surprises later.
Choose your investors wisely
VCs and angels both have the same objective: to help their portfolio companies off the ground and see them succeed. Compared to VCs, angels as private individuals have less deployable capital and often look for exits earlier than VCs (who are often looking for five to eight year exit times). Angels can be fantastic advisors and mentors in their own area of expertise, whereas VC firms typically have more extensive resources and often leverage their long-term partners and extended networks in addition to their core teams’ expertise for the good of their investees.
Choosing your investors well in the early stages of the company can make all the difference to the future of the firm. In addition to the invested capital, professional investors’ greatest value-add in our opinion is the ability to ask difficult questions, spar ideas and serve as a mentor. They can also support the management team and give connections to potential partners and clients. The investor can give a positive touch to future funding rounds when you can show new investors that you already have a reputable investor backing you.
That means you should guard your cap table like your life depends on it. As said before, an ownership structure gone wrong can be a major pain. A long list of shareholders without visible value to the company is not something an investor will be happy to see.
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