Every equity-issuing private company needs a cap table to track who owns how much of the company. This information is critical to helping you decide how you'll manage funding rounds and make major decisions.
The capitalization table that most people think of is merely a representation of all the transactions that have taken place since the company’s inception. In reality, a cap table is made up of many transactions and legal documents, including:
● Stock issuances
● Conversions of debt to equity
● Exercises of options
Needless to say, your capitalization table can get complicated fast. By the time you reach your Series A or B funding, your cap table may look completely unrecognizable. In response, every founder will eventually need to explore the art of capiatlization table management.
Cap table management is the process of accurately and effectively managing all the complexities within your cap table. Beyond simply recording transactions, cap table management involves drafting and signing legal documents, recording transactions, communicating with shareholders and complying with regulations (among other things).
Why Cap Table Management Matters
There are five key benefits to effectively managing your cap table:
- Raise Money on Better Terms
Modeling new rounds of financing and analyzing the impact on shareholders will be key to negotiating with investors and maintaining a meaningful stake for founders and employees. Your cap table will be at the center of these negotiations. If you have an organized cap table from the start, you’re much less likely to make costly mistakes when it comes time to raise capital.
2. Making it Easier to Track/Issue Options
Tracking your equity holdings sounds easy in principle but the reality can quickly get complicated. Existing stock options typically vest over time, so you need to keep track of how many shares have vested for every option grant. If an option holder leaves the company, their unvested options are forfeited, and they have a set amount of time to exercise any vested options before they are also forfeited.
To make matters more complicated, you will also need to keep track of early exercises, restricted stock, transfers, and repurchases. Additionally, all your option expense activity will need to be accounted for on your financial statements under ASC 718 stock expense requirements.
Keeping track of all this can easily become someone full-time job and a single mistake can have severe long-term impact on your business.
3. Hiring Key Employees
With the right info and the right tools, your cap table can be a powerful talent recruitment and retention tool.
We know that equity is a vital component of hiring and retaining key employees at startups. Equity holders, particularly executives, want to have an idea as to what their payout might be at various exit values if the company sells.
For this reason, more and more companies are choosing to be transparent about their cap table with all employees, not just investors and executives. They are even utilizing software that allows shareholders to easily view their holdings, see what options have vested and how much they own in the company. This can be an incredibly effective morale booster, incentivizing employees to focus on the long-term growth of the company.
- Staying Compliant
A major part of cap table management is tax and regulation compliance. The IRS has a lot to say when it comes to the taxation of equity, so you need to make sure you’re doing things accurately. An incorrect or misrepresented cap table can lead to the company or employees paying tax penalties.
Here’s a list of the most common regulations you should be aware of:
1. ISO 100k limits stipulate how many options can vest in a given calendar year in order to qualify for certain tax treatment.
2. IRC 409A regulations require you to do a formal valuation at least once a year to determine an appropriate strike price for options.
3. ASC 718 (formerly FAS 123R) is an accounting requirement for measuring and recording the expense associated with issuing equity-based compensation.
4. Rule 701 is an exemption from being required to register with the SEC in order to issue equity compensation.
5. 83(b) election pertains to the tax treatment of restricted stock awards, and it needs to be filed within 30 days of grant.
- Selling the Company
When it comes time to sell your company or go public, your cap table will be critical for understanding how your equity holders will be paid out. In the case of an acquisition, the acquiring company will likely bring in a team of lawyers to pour over every detail of your cap table. They’ll also look at all of your shareholder agreements, option agreements, and sale agreements to make sure that information is accurate.
Any disparate or conflicting information can potentially delay the sale process or result in legal disputes. And when you’re trying to sell the company, the last thing you want is a lawsuit or a lengthy due diligence exercise.
Beyond the reasons above, investing in cap table management is generally a good business practice. Just like finance or accounting, equity ownership is an important business function that requires time and resource allocation. The earlier you choose to focus on cap table management, the more headache you can potentially avoid further down the road.
In the next section of this guide, we’ll get into the mechanics of cap table management.