Building a great company is an entrepreneur’s top priority. But they should also know how to manage their cap table in order to maximize and retain the value they work so hard to create.
Cap tables play a crucial role in creating wealth for entrepreneurs. You can build a great company worth millions, but if your cap table is a mess, you might encounter trouble and disappointment when it comes time to cash out.
So next to building a great company, being smart with your equity is arguably one of the most important aspects of being an entrepreneur.
We want to help all stakeholders make smart equity decisions and get the most out of their cap table. Here’s a few things we’ve learned from the thousands of cap tables we help manage.
The last thing you want is an error on your cap table when you go to raise money or sell the company. Accurate record keeping is essential.
Hence, you need to track every single transaction on your cap table. This might seem obvious, but you’d be surprised at how many cap tables have errors. Sometimes it’s a math error, other times there is information that is inaccurate or simply missing.
Any error on your cap table will cost you money one way or another – legal fees, misallocated distributions, etc. In the process of transferring data to our software for one of our clients, we found an error on their cap table that would have cost them an estimated $1.5 million in their upcoming financing round.
So keep detailed, accurate records of everything – issuances, option grant agreements, secondary transactions, interest accruals, dividend accruals, board minutes, or anything else that is sent out to shareholders. And make sure all parties involved agree on the same set of information at all times.
Percentage ownership does not equal economic ownership
As your company matures, the capitalization will increase in complexity with various preferred and convertible securities. If you don’t know how these instruments work, you might wake up one day to realize you only get 5% of the cash even though you own 15% of the company.
How is this possible? For one, preferred stock can have a number of rights and preferences that give its shareholders a bigger piece of the pie than their percentage ownership would dictate.
Liquidation preferences, dividends, participation rights and so forth give preferred shareholders downside protection and, in some cases, an immediate return.
Most of the time these special economic rights only come into play in a downside scenario, which isn’t what you’re shooting for anyway. But these terms can surprise you in an upside scenario as well, so always keep them in mind when negotiating investments. You need to know how preferred stock affects the value of your equity.
Convertible securities (debt that converts to equity) can be another gotcha. When running calculations for your next round or modeling exit scenarios, you need to factor in the conversion of any outstanding notes.
These instruments have provisions that allow them to convert to preferred or common stock upon a liquidation event or a new round of preferred stock. If you forget to model them in, your calculations will be wrong.
Convertible securities can also be tricky because they often have warrants, conversion discounts, and pre-money caps that affect how they convert to equity. The math for these provisions is pretty straightforward, but people still get tripped up. Take the time to understand how convertible debt affects your cap table.
The point here is to be careful when analyzing your cap table to determine percentages and proceeds. If you don’t correctly account for everyone’s economic rights, you might make decisions based on incorrect data. And this could cost you big time.
Think about taxes and stay compliant
Every cap table decision has tax consequences. And in many cases you can optimize how you will be taxed by structuring your equity appropriately.
On the flip side, failing to file certain paperwork or comply with certain regulations can cost you or your employees big when it comes time to pay taxes.
Some of the most common regulations to keep in mind are ISO $100,000 limits, Rule 701, 83(b) election, and IRC 409a. ASC 718 is also important for your company’s financial statements. This isn’t a comprehensive list by any means, so you’ll want to consult your attorney and your accountant to get a complete picture.
Nobody wants to pay the IRS any more than they have to or get busted by regulators. Staying on top of these types of issues is crucial to maximizing the value of your equity.
Grow the pie by giving out pie
Wise founders know that the best way to build a great company is to hire great people. And that generally means sharing equity with key employees and investors.
However, there’s only so much pie to go around, so people are naturally stingy when it comes to letting others onto the cap table. But there’s a fine balance between being selective and being greedy.
The trap many people fall into is thinking strictly in terms of percentages, meaning they focus on keeping their percentage ownership as high as possible. But at the end of the day, you want to ask yourself, do I want 40% of $20 million, or do I want 20% of $100 million?
The answer is easy. So when contemplating how much equity to give up, or whether to give any at all, try to keep the big picture in mind.
Ask yourself, will my equity be worth more than it is now (regardless of my percentage ownership) by giving this person/investor equity and incentivizing them to help me build an awesome company?
Obviously you can’t perfectly predict the answer to that question, but having that perspective can help you make better decisions.
Don’t be penny wise and pound foolish.
Get the most out of your cap table
Hopefully this provides you with a helpful framework for managing your cap table. The Shareworks Startup Edition team has worked with thousands of companies and their cap tables, so we speak from experience.
If nothing else, make sure you don’t underestimate the importance of your cap table. Many entrepreneurs have lost out because they weren’t informed or simply didn’t take the time to carefully analyze the consequences of their decisions.
Cap table mistakes will cost you money. So stay informed, consult professionals who know what they’re doing and watch your equity like you watch your bank account.
About the AuthorMore Content by Hannah Bloomfield