Capitalization Tables Demystified
Terms like “warrants, waterfalls and preferences” can be confusing and intimidating when attempting to understand a capitalization table (aka cap table); it is no wonder we are often asked for a simple way to understand them! This article will give a brief overview of why cap tables are important and introduce a simple model to use early in the due diligence process. As fund administrators and instructors for the Angel Capital Association (ACA)’s educational programs, Loon Creek founders Kevin and Denise sometimes develop tools to help investors understand the concepts presented in the courses they teach. Many years ago Kevin developed a simple spreadsheet to model basic cap tables for use by our local angels as part of their regular due diligence process. He introduced this model during his presentation at a recent national webinar for the ACA discussing the basics of cap tables. You can download a copy of that cap table model as well as access the webinar archive from our Resources page. For those who would like a brief primer, a capitalization table is a document that lists all of the owners of equity and potential equity, the shares they own and the percentage ownership those shares represent. Typically, the cap table is organized by type of security and/or by investment round. We believe it is important for angel investors to understand cap tables. It is part of our regular diligence process to first construct our own summary cap table before we decide to invest. Here’s what a rudimentary cap table can help you answer:
Founders’ ownership. What percentage of the company do the founders own now and will be likely to own at exit? As investors, we want to be sure the founders have adequate incentive to continue to work very hard right through the exit.
Stock options. How many shares are set aside for the stock option pool, and is the pool set up before or after we make our investment (pre or post money)? We know the company will not be able to pay market salaries in its early years and that a stock option pool will be needed to attract quality staff. If the pool is set up before we invest, then the dilution associated with the stock option pool goes against the previous investors; if the pool is set up after our investment, then we are diluted as well at the time we make our investment.
Valuation. What is the impact of the agreed upon pre-money valuation? This allows us to see what percentage of the company we will own now as well as projecting that through to exit to see if a) an exit at the required valuation is achievable, b) the likely exit will be sufficiently rewarding.
Subsequent rounds. What is the impact of subsequent investment rounds in terms of dilution, share price, and required exit valuation?
Exits. At various exit amounts what will our return likely be?
We have also found this simple model to be a helpful tool when working with entrepreneurs who are new to the process – often cap tables are confusing to them as well! In our experience, many entrepreneurs rely on a third party such as an attorney to maintain the schedule for them and only understand it at a high level. Admittedly cap tables can become very complicated when they take into account convertible notes, warrants, preferences, waterfalls and other terms and instruments that may impact our return. But we argue that if the simple cap table doesn’t show you that it is possible for this investment to make stellar returns, then you need go no further with negotiations or due diligence.
The ACA has a wonderful advanced course on cap tables that teaches the audience to deal with the myriad of possible return-reducing conditions. Information on this and other ACA courses is available from their website. Click on “Education” on the top ribbon. Meanwhile, we hope our simple cap table model will be helpful to you. Loon Creek specializes in syndicate formation and management services for private investors (and for the companies in which they invest). You can learn more about our services on our website.