When preparing for a cap table, pre- and post-money valuations are some of the key elements that founders must consider and include
Speaking to a potential investor can be a nerve-wracking experience for entrepreneurs. They need to prepare many documents beforehand, and a cap table is one of the most crucial.
According to Investopedia, the cap table (the short form for ‘capitalisation table’) is a spreadsheet or table that shows a company’s equity capitalisation. Startups and other early-stage businesses use this tool to create a detailed breakdown of their shareholders’ equity. A cap table helps you determine the per-share price used in financing.
How can you prepare a cap table properly? What are the elements to be included in it? What mistakes should you avoid?
We spoke to Shirish Nadkarni, founder of three companies, two of which are publicly traded. He is also the author of From Startup to Exit: An insider’s guide to launching and scaling your tech business. We believe that he would be the right person to answer these questions as he had previously written about fundraising in his blog and for the e27 Contributor Programme.
Building a cap table
In an earlier article about the fundamentals of the cap table, Nadkarni recommends founders use tools such as Carta and Capshare to manage equity. However, he also states that using a simple spreadsheet in the initial stages would suffice.
According to Nadkarni, while preparing a cap table, pre- and post-money valuations are the key elements that founders must consider and include. “Note that in calculating your ownership in the company, you should do so on a ‘fully diluted basis,’ i.e. taking into account your option pool and any warrants that have been issued. The share price for any financing will also be calculated by dividing the pre-money valuation by the fully diluted number of shares.”
“For example, let’s say you’re raising US$1 million, and the investors decide that your company’s valuation is US$4 million. That is the pre-money valuation (before they put the money in),” he explains.
“Post-money valuation is pre-money valuation plus the financing amount. In this case, it is US$5 million (US$4 million+ US$1 million). Then the amount of equity that the investors will get for the US$1 million they injected will be US$1 million divided by the size or the post-money valuation,” the investor continues. “Here, the investors will get 20 per cent of the ownership of your company. So, the principles that apply while figuring out the cap table are limited. Typically, when you’re doing the financing, you will determine how big the option pool is for employees and how much equity you pay to give to the new investors.”
There is also a concept called ‘waterfall analysis’. It is a way to determine how much each investor gets when the company is sold.
“Investors typically will have something called preferences. In this case, the investors will ask you to return their money before you distribute the funds to common shareholders,” he said.
Now, let’s consider a new scenario: an investor invests US$5 million in your company. However, your firm doesn’t perform as expected and is eventually sold at US$1 million. Then, the US$1 million will go to the preferred investor, with the common investors receiving nothing.
Another scenario is that a company raises US$5 million from an investor. The firm grows and is eventually sold for US$10 million. Here, the investor has a 20 per cent share of the company, so logically, this backer should get US$2 million out of the US$10 million. However, since the investor has a preference, he/she will walk out with the US$2 million and US$5 million, with the remaining proceeds shared among the common investors.
This is why it is essential to record the order of the preferences and the ownership of each class share. It is something that your legal representative can determine. “This is the calculation that has to be done that produces the waterfall model. We go through each preference first and allocate that money,” Nadkarni says.
What you need to avoid
In our interview, Nadkarni also pointed out the common mistakes that founders tend to make when drafting the cap table. Although these mistakes sound trivial, they can complicate your fundraising journey.
One of those mistakes is forgetting to add employee stock options (ESOPs) in the cap table, which will lead to a piece of missing information that can affect the accuracy of the calculations.
Another common mistake is not including convertible debt in the calculation.
“The problem with convertible debt is it does not show up on the cap table because it’s not equity. Debt is considered future equity because we can convert it into equity at some point. Also, people forget how much dilution they’re giving up,” Nadkarni said. “And it’s when the debt is converted, then they realise that ‘oh my god, I gave up so much equity’. It is another common mistake that founders make.”
This is why Nadkarni stressed the importance of meticulous record-keeping for every startup founder.
“Every time you give away equity in the company, you have to record it. You have to be very diligent about it. Even if you’ve given away 1,000 shares and options to employees out of the total 10 million shares, you still have to record it in the cap table,” he concluded.
e27 has written several articles to help founders in their fundraising journey. We have published articles on the topics such as traction metrics, approaching investors, and questions VCs might ask during a presentation. While these articles are written with beginners in mind, we believe that seasoned entrepreneurs could also benefit from these posts.
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