Feature Article

 

Your Capitalization Table

 

By Brent Hawkins

 

Entrepreneurs are sometimes confused when a potential investor asks to see their "Cap Table." Many entrepreneurs aren't exactly sure what a Capitalization Table (commonly called a Cap Table) is and, even if they do, they're not quite sure why an investor would want to see it. Others may not know exactly what a Cap Table should look like. These reactions demonstrate a lack of appreciation for this critical and misunderstood document. Why is this document so important to investors? What should it include? What should it look like? In short answer, a Cap Table is supposed to be the document that shows who owns what stake in your company. It should show all shares that have been committed by your company to third parties (including those promised, gifted, optioned, accrued, etc.).

 

Getting Started — Some Key Issues and Considerations

So how should you model a Cap Table? Start with a Microsoft Excel spreadsheet. The math functions in a spreadsheet will serve you well — by providing a mathematical cross check to your share numbers and facilitating updates to your Cap Table numbers as you add shares and shareholders. Then, with this foundation, ask yourself some basic questions about your capitalization plans and needs. Among them:

>>> Do you expect to be raising money from your first investors soon? Try to model your capitalization structure so that your share price will be roughly $1. Why $1? That's what investors in our market expect. Is it a problem to have a share price different than that? Not at all, but why not lead with what investors expect? How, then, do you get to a price of $1 per share? Understand an investor's price formula: Price equals valuation divided by your fully diluted shares. So first, take your best guess at valuation. Angel and venture capital investors in our market usually expect initial valuations for pre- or emerging-revenue companies to be in the neighborhood of $1.5 to $3 million, unless you have a more compelling valuation story. Then, understand what fully diluted shares means: the sum of your outstanding stock plus your option plan (more on that later) plus any convertible securities (such as options and warrants) outside of your option plan. Next, set your fully diluted share number so that the pricing math works out to roughly $1 per share. One counterintuitive aside before we leave this topic: Avoid the temptation of taking money at the highest price possible from unsophisticated investors because, if your valuation comes crashing down in a later round, those investors will feel ripped off and very unhappy with you.

>>> How should you treat ownership between the founders? Typically the founder in a CEO role receives more stock than the others. Most investors like to see the CEOs of their companies have at least a 10 percent stake on a post-financing basis so that the CEO is properly incentivized to make the company succeed. Founders in CTO or CFO roles are typically targeted at lesser percentages. But, there are more exceptions than rules here. Some founder groups like the egalitarianism of equal percentages and some founders may have more cash or intellectual property to contribute to the company than others, so should receive stock accordingly. In each case, while it is fine to think about ownership between founders (or any shareholders) on a percentage basis, make sure you document equity on a share basis to avoid confusion about the dilution that will come with later issuances and financings.

>>> Should there be some vesting among your founder group? You may be starting a company with a group of previously high-income, hard-charging young guns. That's good. But young guns accustomed to significant income may give up on your business plan if you do not find success quickly (and new companies rarely do). You may want to model your capitalization to allow for repurchase at an agreed price if a young gun leaves, as sort of "golden handcuffs" to keep them with the company. At the same time, note that vesting can sometimes trigger some unintended tax consequences that can be avoided in large part by making what is called an 83(b) election with the Internal Revenue Service. To see more about 83(b) elections, as they are beyond the scope of this article, click here.

How should you structure vesting? Your choices are time and performance. Time is much simpler because it is totally objective and easily understood. Time vesting is usually handled over four years, with "cliff vesting" of 25 percent at the end of the first year — because employment problems, disputes and fallouts are likely to arise in the first year — and monthly pro rata over the remaining three years. If an employee subject to vesting isn't working out, terminating employment cuts off vesting. Performance vesting also works, but usually carries dangerous and subjective elements that can lead to uncertainties and higher legal costs. For example, using revenue as a performance vesting metric seems easy, right? Wrong. For example, are revenues gross or net? Net of what? Do they include receipts for services not yet performed? Are they based on billings or collections?

Note that if you elect not to have your founder group subject to vesting, a venture capitalist may impose it on you anyway. And the venture capitalist's terms will probably be less friendly than terms you may be able to set in your founder group on vesting issues, such as length of vesting term and acceleration upon certain events (such as the sale of your company or your termination from the company).

>>> Do you need to add members to your founder group? If so, you should consider adopting an option plan and issuing options. Why options instead of stock grants? Stock grants can create an ugly problem: When stock is received at no price or a price less than fair market value, the recipient recognizes taxable ordinary income. Options generally avoid those problems, but beware of tax "gotchas" under new rules of Section 409A of the Internal Revenue Code, which require options to have exercise prices at or above the fair market value of their underlying shares. Because the fair market value for small private companies is usually unclear, companies must have "written reports" from "valuation experts" (which can be officers and directors in some cases, but are usually outside firms — to avoid unintended tax consequences). Section 409A is much maligned (and appropriately so) in the venture community. For more info, click here and read the blog entries that follow.

Why do you need an option plan instead of just stock options themselves? You need an option plan to grant incentive stock options (ISOs), a kind of tax-favorable option. For more about tax treatment of ISOs click here. While the merits and advantages of ISOs are debatable, your target employees are expecting ISOs, so you should strongly consider providing them as a matter of course. Take care to adopt an ISO plan appropriately - Internal Revenue Service rules require approval not only from your board of directors but also from your shareholders.

What effect does your option plan have on the price an investor will pay for your stock? Sadly, sophisticated investors will "price around" your reserved plan share by including them in the denominator of the pricing calculation referenced above. Why? Notwithstanding some compelling reasons to the contrary, that's just the way it is, and arguing strongly against the "price around" will make you seem out of touch with reality. But learn a lesson here: While your option plan should accommodate your immediate option needs, adopting too big a plan will only dilute you.

What percentage of your capitalization should you reserve under your plan? Typically 12-25 percent. Where along that spectrum? It depends. Consider three things: First, the size of your company. If you are a newly formed and unproven company, reserve more shares under your plan. Second, your cash flow and compensation structure. Cash and equity compensation have been described as two ends of a balloon. If, out of choice or necessity, your company squeezes the cash end of the balloon, reserve more shares under your plan. Third, your need for fresh talent. Fresh talent will be thirsty for upside in your company and it's appropriate to give them incentive. If you need fresh talent, reserve more shares under your plan.

 

What a Cap Table is Not

Finally, understand what a Cap Table is not. A Cap Table is a mere summary that relies on other documents — stock purchase agreements, option agreements and the like, which I will refer to as "issuance documents" here. If there is a discrepancy between a Cap Table and issuance documents, issuance documents will control. And there are a number of other actions and considerations that should go along with issuance documents. All issuance documents should be approved by your board of directors. Stock purchase agreements should have stock certificates that relate to them. Stock certificates should be tracked in a stock ledger — a sort of history about what has happened to each stock certificate. You should pay appropriate attention to tax issues and securities exemption issues in connection with issuance documents. Not handling these sort of issues appropriately is perhaps the biggest problem with young companies and is worthy of a separate article.

 

Conclusion

While modeling a Cap Table is not very hard, handling all of the issues and paperwork that goes along with it is. It is also expensive both in terms of legal costs and drain on management's time and attention. So keep your Cap Table and your capitalization simple. Document it carefully. Do it right the first time — it is hard to undo or change. Then, keep your Cap Table up to date as a resource to summarize what you've done.

The Cap Table is an extremely important document that can either help or severely hinder your ability to raise money. Doing it right will show your investors a story documenting your equity issuances and build their trust in you, even if they do not agree with all of your capitalization decisions and assessments. Best of luck!

 

Brent Hawkins is a partner at the law firm of Bennett Tueller Johnson & Deere, P.C., where his practice focuses on issues relating to the formation, financing, governance, strategic transactions, and sale of emerging and mid-size companies.

 

Launch - Fall 2007

 

 

For the full "digital magazine" version of Fall 2007, visit: http://www.nxtbook.com/nxtbooks/growutah/launch_2007fall