The Capitalization Table Decomposed
A deep dive on startup cap table scenarios
November 20, 2017 at 9:47 am
This November, I traveled to San Francisco for the 2017 Afrotech conference, where I had the privilege of addressing close to 2,000 founders and startup leaders. The subject of my talk/workshop was demystifying the cap table and understanding founder ownership. The session was scheduled for one hour and was intended to be very interactive. In all honesty, I had some trepidation about speaking to such a large group with varying backgrounds and experiences about what can be a very technical subject.
In the end, I was pleased with the level of interest and participation during the 60-minute session that probably could have gone on for another hour. There were so many thoughtful questions throughout, and some participants wanted to go steps deeper than what I prepared for the group. A huge thank you to the AfroTech attendees for being so engaged.
Since the talk I’ve received many requests on several channels (Slack, Twitter, LinkedIn, Instagram, Facebook, and email) for the material I used to present and the answers to the questions posed. I’ve authored this post as a response to that demand. Here goes…
The cap table is the document of record for stock ownership (common/preferred) within a company.The cap table is always included, usually as an addendum, in the stock purchase agreement. It is also critical to modeling investment returns. The following is an exercise to teach the fundamentals of the capitalization table. It’s best to use Microsoft Excel or an equivalent spreadsheet program to construct the cap table. For those of you unfamiliar, I’ve included a template that we use at Cross Culture Ventures to model our deals.
The following is a set of exercises intended to take you through a fictional investment scenario to teach the mechanics of constructing a capitalization table. I’ve also included some questions to provoke thought around ownership and consequences of certain investment terms along the way. This will be most useful if you create a workbook with separate worksheets for each exercise before jumping to the answers on a completed worksheet. This is one of those things where you’ll learn more by doing. (hint: each exercise builds off the other so copy your work from the previous exercise into the worksheet for the next exercise and add to it from that point).
Exercise 1: Build a cap table for the following scenario:
- 10,000,000 authorized shares
- 2 founders that combined own 50% FD (2.5M shares of common stock each)
- This is their first round of investment
- The deal is between 2 investors that are each investing $500K (Dope VC is one of them), as a part of a convertible note with a $5m cap or 25% discount, 7% annual interest
- What is the difference between common and preferred stock?
- Common stock is usually reserved for founders, employees, and advisers
- Preferred stock is reserved for investors. It carries liquidation preference i.e. in liquidity events preferred stockholders are 2nd in line (subordinate to debt) for payout while common stockholders are 3rd in line. Additionally, preferred stockholders have voting rights related to protective provisions. Protective provisions refer to specific rights of the preferred and the associated voting requirements. The simplest form would cover any changes to the articles of corporation, changes to the board and approval of financing or liquidity events. In standard cases, a majority vote of the preferred is required.
- What’s the difference between the cap and the discount? Which should be applied to conversion?
- The valuation cap of a convertible note is an implied valuation that serves as an upward valuation risk mitigation strategy for investors/convertible note holders at the time of conversion to equity. For example, if the valuation cap of a Series Seed convertible note is $5M and the valuation of the Series A equity round is $10M, then the convertible note holders would convert their shares based on the $5M valuation as opposed to the $10M valuation.
- The discount is meant to serve as flat/downside protection for convertible note holders. One would elect to invoke the discount instead of the valuation cap when the valuation of the equity round that the convertible note is converting into is equal to or lower than the convertible note valuation cap. For example, if the Series Seed convertible note has a valuation cap of $5M and a discount is 25%, and the Series A valuation is $5M, the note holder would invoke the discount. Put another way, since we can all agree that $3.75M ($5M * 75%= $3.75M) is a lower price tag than $5M the note holder would elect the cheaper option.
Exercise 2: Build a cap table that follows up with series A, scenario below
- One year later, Series Seed notes convert at the lower price ($5M cap or 25% discount)
- Series A pre-money is $13M
- $2M round with 2 new investors ($1m and $.5m respectively)
- Dope VC invests an additional $.5m
- 20% option pool pre-investment
- For the note conversions, should the price per share be based on the note cap or the discount? Why?
- The series A valuation of $13M is higher than the convertible not valuation cap of $5 so the noteholders would invoke the valuation cap. By the number, the price per share of $.76 is a lower than $1.22 ($1.63 * 75% = $1.22) so the noteholders would pick the cheaper price tag of $.76.
- For the note conversions, what should be the investment dollar amount for each investor? Is it different from the $500k in exercise 1? If so why?
- Yes, it is different because the convertible note also has an annual interest rate of 7%. This means that although the convertible note investors only invested $500k each, they will get credit for having invested $535K ($500 * 1.07) each.
- Does it matter if the option pool is increased prior to the close of the series A?
- Yes, it does matter. The option pool represents dilution for existing equity owners. As such investors typically prefer that the option pool be created/increased prior to the closing of the investment round. No-one wants to get diluted on day one.
- By the numbers: price per share = pre-money valuation/ all shares outstanding, so if we increase the denominator (number of shares) then the price per share gets smaller, which is what investors prefer.
Exercise 3: Build a cap table that builds on the series A deal for series B
- Occurs one year following the Series A investment
- $20M pre-money
- $10M investment round
- Two new investors invest $5M and $2.2M respectively, with all existing investors investing their pro-rata
- 10% option pool remains after grants to new employees after the series A
- Increase option pool to 15% total series B pre-investment
- Are there enough authorized shares to complete the transaction?
- No, there were only 10M shares authorized.The company would need to amend its corporation documents to authorize additional shares. The number of shares authorized carries tax implications, which is why companies typically authorize a reasonable number of shares and then increase as needed. Consult an attorney to better understand tax and to determine the initial number of shares to authorize when incorporating.
- Technically this would have to be amended as a part of the Series A because the total share count after the Series A was 11M +.
- Why is fully diluted ownership important?
- Fully diluted ownership refers to the amount of the company that an individual or entity owns after considering all classes of stock. Put it another way, what percentage of a company’s stock does an individual or entity own.
- This can be important when considering voting thresholds. In some cases, preferred and common stockholders vote as a single class. By understanding fully diluted ownership one can determine which individuals and entities are required to pass a certain measure.
- Ownership is also important when calculating profits/payouts at liquidity events. In the simplest terms, an induvial/ entities payout will be determined by their ownership. For example, if you own 10% of a company on a fully diluted basis and that company is sold for $10 then you will receive $1. This example doesn’t consider debt or senior liquidation preference — meant to be very simple.
- Why should investors and founders care about preferred ownership?
- As mentioned earlier, preferred stock is reserved for investors. Preferred stock carries voting rights related to protective provisions. Protective provisions refer to specific rights of the preferred and the associated voting requirements. The simplest form would cover any changes to the articles of corporation, changes to the board, and approval of financing or liquidity events. In standard cases, a majority vote of the preferred is required. So, founders should consider these voting thresholds and the preferred ownership of each investor. As a founder, you likely would not want one single investor to be able to control the fate of your company.
Exercise 4: Exit scale/ scenarios
- Revenue is at $200m two years after series B
- There were no investments after series B
- Exit multiple is 5x
- If a series C investment took place prior to the exit and Dope VC didn’t participate in the round, what would we need to consider?
- Dilution! If Dope VC or any other investor doesn’t invest at least their pro-rata in subsequent rounds of equity funding, then they would reduce their ownership stake in the company.
- What is the primary difference between IRR and exit multiple?
- IRR considers time value of money or the timing of outlays (investments) and returns. Exit multiple only considers money out and the return.
- How would a 2x liquidation preference impact the return of the investor and the common stockholders?
- Liquidation preference refers to the order in which investors receive their payout in the event of a liquidity event e.g. preferred class gets paid out before common class. There can also be seniority within the preferred group e.g. series Seed can be junior to series A, which means that the payout order (liquidation stack) would be Series A, then series seed followed by common.
- There is always a multiple assigned to the liquidation preference (1x, 2x etc.). 2x would mean that the preferred class would be paid 2 times their ownership stake.
- Participation refers to what happens after 1x is achieved by the senior class(es) of stockholders. Participating means that once the 1x preference is achieved that all stockholders will share the remaining proceeds ratably.
- Example: 2x participating liquidation preference, Investors own 40% of a company that sells for $100 and the preferred holders are pari pasu (equal). Preferred would get $40 before the common starts to receive a payout. Following that 1x or $40 payout, the remaining proceeds ($60) will be distributed ratably to the holders of the Common and Preferred on a common equivalent basis until the preferred has been paid $80. Once the 2x or $80 payout is achieved the preferred would stop participating and the remaining proceeds would be distributed ratably among the common. Note that if there were debt, then the debt would be paid back before any payout to investors.
Marlon Nichols is a co-founder and managing partner at Cross Culture Ventures (CCV), an early stage venture capital firm with a focus on cultural investing (global trends and shifts in consumer behavior). Before founding CCV, Marlon was an investment director at Intel Capital where he completed his Kauffman Fellowship. Prior to his time in venture capital, Marlon led successful careers in software and strategy consulting in the technology, private equity, media and entertainment sectors. Some of Marlon’s investments include Gimlet Media, Hingeto, LendStreet, LISNR, Mayvenn, Mirantis, MongoDB, mSurvey, Wonderschool, Ready Responders, messageYes, Sidestep, Skurt, Thrive Market, etc. Marlon earned a Bachelor of Science in MIS from Northeastern University and a MBA from the Johnson Graduate School of Management at Cornell University. Marlon currently serves on the board of directors for private companies LISNR, mSurvey, Ready Responders, messageYes, Shottracker, Sidestep and Wonderschool. Marlon was a TechWeek 100 winner, named to Silicon Republic's list of 26 venture capital professionals spearheading change in technology investing, named one of 28 Black founders/ investors making an impact in technology by Pitchbook, a recipient of Digital Diversity’s Innovation & Inclusion Change Agent award, named a member of theRegistry's 40 under 40 Top Diverse Talent, and was recognized among music, film, and technology icons as a Culture Creator. Marlon has been featured in Fortune, Black Enterprise and many other magazines, blogs, and podcasts.