Cap tables 101

The capitalisation table is a snapshot at a point in time of the outstanding equity of a company, outlining the total market value of the company and its components. The cap table is a key point for reference for business managers and investors alike, meaning it is crucial that the cap table remains accurate and regularly updated, as it will often be consulted in every financial decision that has an impact on the market capitalisation and the company’s market value. 

When looking at what the future cap table may look like after one of more transactions, the table is known as a ‘pro forma’ cap table.

Cap tables are important for several reasons:

  • Shareholders can keep track of how much of the company they own
  • Prospective investors want to know how much of the company they will own should they invest
  • Founders and investors want to know how much of the company they are giving away if they offer more shares
  • Investors and founders want to assess how much they will benefit at an exit event, such as the sale of the company

A cap table is made up of many transactions and legal documents, such as stock issuances, sales, transfers, cancellations, conversions of debt to equity and exercises of options. Cap table management is accurately and effectively managing all of these complex transactions. 

Cap table dilution is an important concept for start-up founders to understand. Dilution in start-ups is the decrease in ownership for existing shareholders that occurs when a company issue new shares. There are two senses of dilution. In its narrowest definition, dilution is just that ownership decreases due to new equity issuances. In a more general way, dilution is the loss of value of existing shares due to new equity terms. 

A good example of understanding the difference between these two is to imagine two term sheets a company is considering. Term sheet A and term sheet B. A and B both offer the company £1,000,000 at £10 per share. But B has an additional provision where the preferred stock has a 2x liquidation preference (liquidation preference is explained below).

In the narrow sense, the dilution is identical for both term sheets. However, the value of the founders’ shares will be significantly lower with term sheet B. This is due to the fact that Term Sheet B investors get 2x their money back before the founders get anything. 

Another simple way of viewing the effects of equity dilution is to use the following equation, introduced by Paul Graham. 

Value of ownership after dilution > 1/(1-N)

N is the amount of ownership you are giving up as a percentage. The simple concept of the equity equation is that founders want to maximise their ownership stake. If they were to dilute their ownership stake by N, then the company’s value would have to increase by 1/(1-N) to make their equity worth the same as it was before dilution of the equity stake. 

Liquidation preference

The liquidation preference is a form of downside protection for preferred stock. Such that if the company fails, a liquidation preference provides investors some hope of not losing all their money. 

The most typical liquidation preference is 1x invested capital. Which means when the company is sold, preferred stock holders are entitled to receive an amount equal to what they invested before more junior classes (such as common stock) can receive anything. Alternatively, preferred shareholders can convert their shares to common stocks and receive a cash amount according to their percentage ownership in the company. This is why having an accurate and up-to-date cap table is crucial.

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