Originally posted on Startup Grind
One of the most important things a CEO does is allocate capital using a Capitalization Table, or Cap Table, which gives investors valuable information about who owns the business and what the founding team thinks about financing, ownership, and exit strategies.
The Cap Table also reveals how many people own percentages of the company, how much stock has been issued, and how much is outstanding. Additionally, it shows the debt outstanding, whether that’s traditional or convertible. If you want to learn more about cap tables sign-up here for my mailing list or reach out directly. Most importantly, there are four specific things investors look for in your Capitalization Table:
Cap tables containing so many investors that the table requires page breaks are a red flag for most investors. Having lots of investors can be distracting, which translates into risk for a new investor. Investors also like to own large parts of the company. Negotiating future ownership stakes with lots of small owners is, therefore, risky for investors.
Combine groups of investors into larger cap table entries with defined and contractual points of contact. You can also manage the investors through an investment platform such as DreamFunded or an electronic cap table solution like Visible.
The Cap Table shows how much capital investors contributed and who owns which percentages. If you outsourced any work in exchange for equity, this will also show up on the Cap Table. Investors like to see a complete team with long term incentives to stick with the business. The less equity the team has or the more unevenly distributed ownership is, the greater the risk.
It will take a decade or two before your innovation is mature. Keep as much equity as possible for team members and investors involved for the duration. Employee option pools of 15-30% are normal. Use the Open Sours Guide to Equity Compensation as a resource. Giving away equity to outsourced partners for one-time contributions is not wise.
Missing an obvious assumption or fact at some point is inevitable. You don’t, however, want to miss anything that makes your Cap Table or exit scenario seem impossible for investors. There are three simple things you can do to ensure your Cap table doesn’t include an impossible scenario.
Look at who owns what percentage of the company and how much return each investor requires in dollars. This is usually a 10-30x multiple of the amount they invested.
Examine how much revenue growth the team can create given the amount of capital invested. Is the $10M investment enough to get your business to $500MM ARR?
Calculate the value of an acquisition at 6-8x the calculated revenue from step 2. Divide the revenue among all owners and subtract the dollars each investor wanted back from step 1.
At the end of this, if you’re left with negative numbers, you’re business model can’t support that much investment. Investors don’t want negative returns are the only possibility.
We all play favorites, but the Cap Table isn’t a great place for this type of behavior. I know you want to give every investor something special, but don’t do this with the Cap Table. Calculating who gets what during an exit is easy when terms are standardized. When each investor has their own unique terms, the calculations become too complicated, which introduces risk.
Forgetting to include a single investor’s 2x liquidation preference could be the life or death of an investor’s fund.
Optimize for the terms that will make the entire company a success. Keep all investors aligned as possible. If an investor offers unique value, repay them through deal flow or an advisory or board role with the company.
Managing your cap table and equity compensation takes research, planning, and thought. It is, therefore, a great area to get advice from investors, lawyers, and other founders. A clean Cap Table and solid equity compensation plan can be worth more than a million dollar investment alone.
What challenges have you encountered while constructing your Cap Table?