How To Read and Understand the Cap Table

This article will explain what a cap table is, what its different elements are, and how to read a cap table.

How To Read and Understand the Cap Table

Setting up a cap table is one of the first things that new businesses must do in order to raise capital from investors. Investors do not get the same level of transparency for a company's financials as they do with a public company because start-ups are private. As a result, the cap table is an most important resource for any investor. This article will explain what a cap table is, different elements of Cap Table, and how to read a cap table.

What is a Cap Table?

A capitalization table, also known as a cap table, is a document used by private companies to track their securities, equity ownership of all shareholders, and equity value. Typically, the following types of information are included in Cap Table:

  • Common Shares  
  • Preferred Shares  
  • Convertible Notes and warrants (and who owns them)  
  • Amount Invested by the Investors for securities‌  
  • Valuations of the shares

The cap table is usually the first document that a new company or Startup must create. After a few rounds of funding, the details of the cap table can become more complex and include additional information and transactions such as:  

  • A large list of additional shareholders / investors
  • Different Option & equity plans issued to different Investors
  • Exercised options

Cap tables also refer to other legal documents that outline events that have occurred since the company's Incorporation, such as:

  • Stock issuances
  • Transfers of Shares
  • Cancellations
  • Conversion of Debt to Equity‌  

How are Cap Tables Used?

Cap tables are used by venture capitalists, investment analysts, and founder's to review significant events in a company's history, such as the issuance of new securities, ownership dilution, and employee stock options (ESOP).

Cap tables are used by Pre-IPO companies in the following ways:

1. Raise Funds  

When start-ups begin negotiating with potential investors, they usually want to know who owns the company and what has changed since the last round of funding. As an investor, you should look to cap tables for answers to your questions about a company's potential, such as whether it is facing any potential legal issues and where it ranks if the business is liquidated. Ideally, you want to be as close to the top as possible in order to maximize your return on investment.

2. Comply with Tax Requirements and Other Regulations

In the United States, cap tables are regarded as a formal legal record of equity ownership. They are used by tax authorities to determine whether a company, along with its employees and investors, has paid all of its taxes. So, if you decide to invest, make sure the company's cap tables are regularly updated so you don't end up with an unexpected bill for other people's mistakes. ‌‌  

3. See the Impacts of Various Decisions

Cap tables enable Pre-IPO companies to examine how various business decisions would affect the company's equity structure. As a shareholder, you can also see the effects and understand what you stand to gain or lose if company owners make a decision. This is an essential part of fundraising, and software can greatly assist in this analysis.

What are key terms used in a Cap Table?  

To be a successful investor, you must first understand the standard terms used in cap tables. The key terms listed below appear frequently in cap tables.

1. Debt

A company borrows money that must be repaid with interest.

2. Equity

This is a stakeholder's share of a company's capital. Shareholders gain a controlling interest in the company and benefit from positive financial results.

3. Common Stock

Each share of common stock you buy gives you a stake in a company. As a shareholder, you gain certain rights to company profits as well as a say in how the company handles issues that affect its bottom line.  

4. Preferred Stock

A preferred stock is a group or series of stocks that entitle the holder to special rights and privileges. Investors who own preferred stock have priority over those who own common stock.

5. Stock Options

Stock options  provide you with the right to buy a specific number of shares at a set price during a certain period. They are typically issued according to the terms outlined in a stock option plan from a preapproved share pool set aside for that purpose.  

6. Warrants

Warrants are similar to stock options in that they represent a contractual right to purchase stock at a later date. Warrants, on the other hand, are typically one-time transactions that are not covered by a stock option plan, unlike stock options, which are issued through a stock option plan.

7. Option Pool

Option pools are pre-determined amounts of stock that are set aside for distribution to senior management and employees.

8. Pre-Money Valuation

This describes the value of a company prior to equity investments. The pre-money valuation is determined by negotiations between company owners, new investors, and existing investors.

9. Post-Money Valuation

This describes the value of a company after equity investments. The value of the pre-money valuation is added to the total equity cash received to calculate the post-money valuation.

10. Authorized Shares  

This is the number of shares that a company has authorized for current or future issues.

11. Outstanding Shares The post

money valuation is divided by the total number of fully diluted shares available in this calculation.

This is the number of shares that have already been issued minus ungranted options. Outstanding shares do not include granted options that have not been exercised.

12. Fully Diluted Shares

This is a single number that represents the number of shares that would be issued if all outstanding contingencies were met by shareholders. Included are all granted options, restricted stock, warrants, and the remaining option pool.

13. Price Per Share

The post-money valuation is divided by the total number of fully diluted shares available in this calculation.

14. Convertible Debt

This is debt financing that can later be converted to equity. Convertible debt has specific parameters that govern when it can be converted into equity. Furthermore, convertible debt can earn interest until the conversion occurs. ‌

Convertible debt is frequently used by pre-IPO companies to avoid valuation questions from initial investors. When considering investment options, keep in mind that failing to obtain a valuation can lead to problems later on.

15. Convertible Note

This is a type of debt that is not intended to be repaid in cash. Convertible notes are intended to be converted into company stock in the future. Pay close attention to investors who own convertible notes and how they rank. They are the first in line for repayment if the company is forced into liquidation. You should always be aware of the following:

The debt that a company currently owes  

  • The debt that a company currently owes  
  • How much of it is convertible  
  • The terms of the conversion‌  

Each of the above factors influences how much of your investment you can recoup. Keep an eye out for details like these:

  • What date the company incurred the debt  
  • The interest rate on the debt  
  • How the interest rate gets calculated (annually, semi-annually, cumulatively, etc.)  
  • When the debt is due  
  • The terms and conditions of any conversion‌  

How do Cap Tables Change?

During a company's seed stage of funding, cap tables are typically kept simple. If there are only three owners, for example, the cap table reflects the share distribution. This changes when a company hires new executives, investors, or creditors.

Businesses frequently attract top executives and personnel by offering benefit packages that include options and warrants. These are typically drawn from a variable-size option pool. Option pools can sometimes account for up to 25% of a company's outstanding shares. ‌‌Events that can result in changes to a cap table include:  

  • The creation of an option pool.  
  • Someone exercising their options or warrants.  
  • Any transfer of shares from an owner to a different entity, such as another investor.  
  • The departure of an employee from the company, resulting in the termination of any unused options, share awards, or expired warrants.‌  

During the early stages of a startup, capital can come from a variety of sources, including family, angel investors, and venture capitalists. Any capital raised can be converted into equity or debt, and both should be recorded in a cap table. If you do the following, you may notice a new column in the cap table:

  • Shares of new or existing security are sold  
  • Convertible debt is issued through a note  
  • Warrants are issued during a debt or equity round of financing‌

Understanding Waterfall Analysis

The term "waterfall analysis" refers to the process of calculating money payable to shareholders listed in a cap table if a business is liquidated based on available funds. The events that can lead to liquidation are frequently erratic.

With waterfall analysis, you rely on various assumptions to determine the percentage of funding payable to shareholders in the event of a company liquidation. Furthermore, during the waterfall analysis calculation sequence, you apply various investment decisions, such as anti-dilution provisions and liquidation preferences, into a cap table in the order required to make them "flow" through to the end. Because waterfall analysis is so complex, many potential investors rely on cap table software to model various scenarios.

About Jordensky

At Jordensky, we are committed to providing an experience of the highest caliber while specializing in accounting, taxes, MIS, and CFO services for startups and expanding businesses.

When you work with Jordensky, you get a team of finance experts who take the finance work off your plate– ”so you can focus on your business.

Also Read,

10 Things to do after Raising Money from Investor for your Startup

The Startup's Founder Guide to Understand the Cap Table

4 Factors Investor looks in your Cap Table