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Raising money the right way
Raising money the right way
There's a right and wrong way to do everything.
So you had an idea, scraped together your savings and through a combination of cunning, guile and frugal pragmatism have managed to get an MVP ready to go.
The feedback has been amazing and you realise you’re onto something that could be, well, something.
And then it hits you, to take the next steps, to really be able to hit those next major milestones, you’re going to have to raise some money and that sends you into a panic.
How are you going to raise investment, you don’t have a bunch of family and friends with cash, you don’t even really know how much you should raise and are worried you’re going to spend it on the wrong things.
But, whilst as founders ourselves, we can understand that anxiety, this blog serves as a guide to raising money the right way.
If there’s a right way, what’s the wrong way?
It’s worth taking a moment to think about the sort of things that folk get wrong when they go out to raise money and almost working your way back from there. From the work we do, here are some of the most common mistakes we’ve seen founders make:
- Not having a plan.
- Taking a spray and pray approach.
- Trying to raise venture capital when you shouldn’t.
- Not researching the stage, verticals, and thesis of their prospective investors.
- Raising too much.
- Raising too little.
- Not having the right materials.
- Underestimating the amount of time it takes.
- Overestimating the value of the business.
- Not looking at all potential sources of capital
Have a plan
If you’re reading this blog you’re already ahead of the game because it means that you want to ensure that you approach your fundraising in the right way. Planning for your fundraiser is about getting things done in advance, like prep before you cook a big meal. Make sure you have your materials ready, you know who you’re going to approach, who you’re prioritising and why.
If you approach the fundraise in a haphazard way, investors will pick up that and it’ll jeopardise your chances at success so, always have a plan.
Personalise your approach
It is way too easy to assume that you can just take a spray and pray approach to raising investment. All these folk on LinkedIn with angel, or investor in their profile must be desperate to see your business right?
Wrong.
It is really easy to see who has thought a little about the person on the receiving end of the email or message, and it’ll probably make that person far more open to actually opening your message and having a look at your materials. And even if the investment isn’t for them, it will probably make it a lot more likely that they will give you feedback or even open up their network to you if they can see you’re the sort of person that takes a bit of time to tailor your approach and messaging. It shows you what to build a relationship and aren’t treating this as transactional.
It’s ok not to raise venture capital
We see businesses wasting their time trying to raise venture capital all the time. Why? Because they think the fundraise is the important thing, not a means to an end, or they’re more interested in the headline than the milestones or, and unfortunately, this is the reality for most, they just don’t understand how venture capital works and whether their business fits the model.
How venture capital works is a whole nother blog, but the thing to remember is that VCs are looking for a couple of substantial things – a HUGE market, a team that has proven execution abilities, some form of the moat that will protect their business and that all of this will lead to an exit outcome in the future which has the potential to return the WHOLE fund (not just the investment made).
The reality is that most businesses don’t fit this model and that’s ok, there is nothing wrong with building a great business that makes money and employs people. So take a long look at how big you believe your business can get and whether you, yourself are that interested in or even capable of trying to build a billion dollar venture and if you do decide to chase VC money, at least you’re doing it with your eyes wide open.
Send your fintech deck to a fintech investor
This is part and parcel of personalising your approach. Research the investors that you are interested in bringing on to your cap table, and ensure that you know that you fit their thesis.
What does this mean?
Most investors will have a pretty specific idea of the verticals (industry sectors) they will invest in, the stage (early, seed or growth), and the cheque size/target ownership they’re looking for. So if you are a pre-seed, fintech business raising a £300,000 round, don’t approach a Series A, edtech investor who deploys £1 – 5m cheques and needs 10% ownership.
The great news is that whether on LinkedIn, Twitter, or their website, almost every investor publishes not only their thesis but also the best way to contact them. Some want emails, others have a form (see ours here), and others still will accept a DM as a first step.
Raising the right amount
We’ll talk about the problems with raising too much money and raising too little money – from an investor’s perspective in a second but the first step is actually working out how much you need to raise at all.
And this comes down to having a decent financial model where you can understand – and importantly explain to others – your numbers. As you might imagine, we see a lot of broken financial models with hard-coded numbers, circular references, and all sorts of Excel newbie errors – not to mention the poor understanding of financials in general.
This is where tools like Projected come in very handy, it’s quick and simple to get started with and because it’s built by CFOs and founders, it’s got exactly what you need.
Raising too much
It’s easy when you’re embarking on your fundraise, to just try and raise as much money as you can. This can send a poor signal to investors because it shows you haven’t thought about ownership structure, valuation (as compared to traction) and they would worry they risk spending their money funding endless experiments rather than a coherent plan.
Raising too little
The flip side is not raising enough money to get you through to the next milestone. Investors want to know that you have sufficient runway (cash availability) to see some significant traction. That means that as a founder, you are going to be in constant fundraising mode and not focussed on building. It may even suggest that you have misjudged your growth or revenue projections significantly which would be of concern – investors never expect you to hit forecasts fully, but they don’t want to see fantasy either.
Materials, Materials, Materials
It is not enough to just have a deck and assume that that is enough to get you through a fundraise. But your deck needs to explain the key problem and solution as well as show the market size and business model and, critically, should be well and, professionally, designed
You should expect investors to want to see not only the deck and financial model, but they’ll also want to dig into your data room.
This means they’ll want to see things like your accounts, cap table, significant contracts, technical road map, shareholders agreements, articles of incorporation and all sorts of other bits and pieces to complete their due diligence.
It’s really easy to let this derail a process if the various documents aren’t available (again showing a lack of planning and preparation)
Give yourself the time you need
Most founders underestimate the amount of time it takes to raise a round and again smacks of a lack of planning. You never want to be in a position where you have to take the first deal that’s on the table because you may have to wind things up if you don’t.
At later stages especially, expect a fundraise to take anywhere up to 6 months. Remember you will be talking to 100 – 200 investors and will likely face a lot of rejections (that will help hone your pitch), before getting to a yes.
That takes time.
And all the time you will also need to run your business without going crazy. So give yourself sufficient time and headspace to get through. It’ll never be perfect, but leaving it to the last minute is just going to put yourself under pressure that may derail the whole process.
Valuation is a negotiation
Confidently putting on your deck that your business turning over 200k is worth 10m (and yes we have seen this!) may have flown in 2021 but it won’t fly today. Overvaluing your business shows naivety and undervaluing your business means that either you’re desperate or you’ll be easy to take advantage of – neither of these are good looks when an investor is considering your business.
Valuation is always a negotiation, it is the price at which investors will purchase equity in your company and the price you will accept to sell that equity.
So don’t sweat the valuation till you have one, or preferably multiple, term sheets in your hand.
Not all capital is created equal
With all the headlines, it’s no surprise that founders often default to looking at investment as their best source of finance, but it’s actually the most expensive form of financing your business.
If you haven’t already, you should consider the other types of finance that are out there from revenue based financing, to startup loans, to R&D tax credits or grants to invoice factoring to our personal finance, sales!
Remember, your job as a founder is to keep the wheels turning, however you can.
So there we are, our guide to raising money the right way, hit us up with your best tips and tricks to running the capital raise gauntlet.
CFO versus Accountant – An Insight into Strategic Finance
CFO versus Accountant - An Insight into Strategic Finance
Understanding the vital differences
You would be surprised the number of times we’re asked to provide basic bookkeeping services or whether we can run a company’s payroll and as startup CFOs we get that many founders wouldn’t have had the exposure to understand the difference between an accountant and a CFO, so in this post, we’re going to clear up some of the most common misconceptions of what a CFO is and why we’re not your run of the mill grey-suited number cruncher.
The first major difference is that an accountant is traditionally external to the business whilst your CFO sits inside – often as a member of the senior team. Even portfolio, outsourced or fractional CFOs whilst not employed by the business will be intimate with all the inner workings.
Secondly, accountants tend to be task focussed. They will have monthly, quarterly or annual tasks (such as filing your VAT returns or annual accounts) and their measure of success will be getting those done on time. CFOs, on the other hand tend to be more project and long term focussed. What they do tends not to follow a specific routine because it is highly dependent on the state of the business as well as the macro environment at any given point in time.
Accountants tend to look inwards and backwards. That is to say they focus on internal reporting of what has already happened whilst CFOs tend to look outwards and forwards. What this means is that they are constantly gauging the market, the competition, the opportunities and whilst they need to know what has happened they are much more interested in influencing how the business performs moving forward.
Accountants tend to be technical whilst CFOs tend to be commercial. What this means is that an accountant can tell you why they have applied a specific IFRS or GAAP standard (accounting speak for technical treatment), a CFO will be more interested in the implications it has on a business’ performance. They will be focussed on customers, margins, automation, revenue and cash flow whilst accountants will be more concerned with controls, processes and the minutiae of debits and credits.
It’s worth noting that a strategic CFO is only really valuable for your company once you have hit certain milestones. That might be having secured your first customer and taken your first revenue or it may be when you raise external investment for the first time or even as you start to scale or look at mergers and acquisitions activity. And for them to do what they do well, it’s imperative that you have the basics in place in your finance operations which is where a great accountant can really help out.
So when you’re thinking about how to make sure you’re compliant and not going to run afoul of the tax man, that’s when you should talk to a good accountant, but when you’re ready to grow and can see a bunch of opportunities ahead of you but want to ensure you’ve figured out how much cash you’ll need, where it’s going to come from and what sort of return makes sense, that’s when the right strategic startup CFO can really make a difference.
Ultimately finance sits on a spectrum from the highly technical through operational and out the other side into the strategic, where most CFOs prefer to sit. Both roles are necessary in a fast growth venture but if nothing else, it’s important to understand that they’re rarely going to be filled by the same person.
What do you have in your business right now and what do you think you need to supercharge your growth?
All about the Accelerators
All about the Accelerators
What you need to know
You can’t move anywhere in the early-stage venture ecosystem without coming across accelerators. There is an abundance in the UK and globally – so much so that it seems every new headline in tech news is about a business getting accepted to a hot new accelerator programme.
But for founders, it may not be entirely clear what the value of an accelerator is for their business. And how to choose the right one. As startup CFOs, we often get asked our opinion on whether it makes sense to join an accelerator, so we thought we’d break it down for you in this short post.
What is an accelerator?
Let’s start with the basics, an accelerator is a programme that is run to help founders and their ventures grow at a faster pace than they would have if they had not joined the programme (hence accelerator). Not to be confused with an incubator which is typically a studio where new businesses are conceived and built.
Accelerators have traditionally been in-person, on-campus programmes though as with many other norms that changed during the pandemic many are offering fully virtual programmes or have moved to a hybrid offering.
What is it going to cost me to join one?
This will, of course, vary from accelerator to accelerator, but typically you should not expect to pay in cash for access to an accelerator programme. Instead, the accelerator will normally offer a range of services, and even some cash, in exchange for equity in your business. Whilst many of them will purport to have a fixed percentage in mind, it is always good to negotiate with them.
We would highly recommend against accelerators that ask you to pay cash to attend them as in our opinion that is quite a predatory practice targeted at first-time founders who may not have the right knowledge or advice to navigate the offer.
So what do I actually get out of attending?
This is the crux of the matter and will depend on the brand of accelerator that you attend. Broadly speaking you’ll be offered the following services which depending on your business and stage you’ll need to varying degrees.
Mentorship and Office Hours
Accelerators pride themselves on having great people, often exited founders themselves, available to new cohorts and who will provide mentorship and coaching as the business grows.
Sector Expertise
A number of accelerators will have deep expertise in one particular industry or technology, whilst others may offer this expertise across a number of verticals.
Office Space
One of the huge benefits of an accelerator is access to their office space which, apart from being a valuable resource in itself, also means that you can rub shoulders with other founders and teams going through similar growth journeys. Founding a company can be very lonely and this benefit is quite underappreciated.
Access to Talent
Many accelerators will have their own talent function where they can help ventures source great team members whilst others go one step further with members of the core accelerator team co-opting into your business and potentially joining full time down the track. This can be really valuable when you need high-quality individuals but don’t want to pay full-time salaries.
Events
There is a range of events that accelerators put on, from demo days to dinners to educational seminars on specific topics. These can range from lunch and learns about how to best build a financial model to larger industry events aimed at showcasing cohort companies.
Funding
Some accelerators are attached to funds and hence can invest directly, whilst others simply have great relationships across the funding landscape. If your main aim in joining an accelerator programme is to get yourself funded then you will want to think carefully about which model suits you best.
Network
In our opinion, the most important function of joining an accelerator programme is the halo effect you get from their brand and the access to their network. If the accelerator doesn’t have a huge Rolodex of contacts within VC funds, corporate partners, angel investors and networks, founders and talent in general then they are not likely to be providing you with any value at all.
So, should I join a programme?
As with many things in life, this ultimately depends on your situation and what your objectives are.
Accelerators can be really valuable if you are stuck at a certain level of growth, or can’t find the right talent or even the right investors for your business. But they can also be a massive distraction from building your business as you spend so much time attending events, bootcamps and sessions that you have to ensure there are enough people left in the business to run it.
The equity cost might exceed the value the accelerator actually brings to the table so you need to weigh that up carefully but for some programmes like Y Combinator, the halo effect of having been accepted is worth the cost.
Whatever you do, you should think through the pros and cons carefully and if at all possible speak to other founders or companies that have been through the same programme in the past.
So there you have it, almost everything you need to know about accelerators, if you’re interested in learning more, I’d strongly recommend you listen to our podcast with David Hickson, one of the founding team at Founders Factory, a leading UK (and now global) accelerator or with Jenny Ervine, Co Founder of Raise Ventures a Northern Ireland based accelerator supporting the NI and UK wide ecosystem.
Other Finance Options for Start-Ups Beyond Angel and Venture
Other Finance Options for Start-Ups Beyond Angel and Venture
Maximising cash, extending runway
As startup CFOs it should come as no shock to anyone that we are constantly looking at ways of maximizing cash, extending runway, and optimising the capital structure of the businesses we advise.
Over the last several years, there has been a proliferation of new options available for startups – especially here in the UK – that are looking for ways to finance their business without going out to angel investors or Venture Capital firms.
So here are some options available to founders and their businesses that you might not have thought of before.
Startup Loans
These are government loans available from a number of sources and are ideal for founders that need a small amount of capital to get things underway, maybe to get a prototype built, or to buy your first stock or whatever might be that first step that gets you on your way.
These loans are aimed at UK residents over the age of 18 who pass necessary credit checks. They are currently structured as unsecured, personal loans repayable over 5 years at a cost of 6% per annum. You can find out more and check to see if you’re eligible via the startup loan website.
Convertible Future Earnings Agreement
There have been a few iterations on the income share agreement that has led to the Convertible Future Earnings Agreement (CFEA), but at its simplest, it’s an instrument where you pay back a fixed percentage of your income for a predefined period of time after you reach a certain level of income. The convertible element comes into play if the business then goes through a more traditional equity financing round and the balance is converted normally with a discount or cap to the round.
This type of finance is more suitable for founders that don’t want to sell a lot of equity in their business, who are looking to grow efficiently rather than the sort of fast growth associated with venture-backed businesses. You can find out more about the CFEA via one of its biggest champions, Horizan VC.
Grants
Grants can be issued from a number of different parties, from charities and foundations to government institutions. They are typically funds released to businesses in the pursuit of some form of research and development activity that leads to an innovative breakthrough or commercial activity. The application process can be quite difficult to navigate depending on the nature and size of the grant so be prepared to put in a fair amount of effort and wait a fair amount of time before you get a response.
Whilst some grants are given without the expectation of repayment, others may need to be repaid dependent on some predetermined conditions (such as securing match funding, hiring a certain number of people in an area, or commercialisation of the research and development activity). In the UK you may wish to check out Innovate UK to see what grants may be available right now or you may wish to speak to a specialist such as GrantTree who will write your applications for you – for a fee of course.
Working Capital Solutions
Next up are the more traditional forms of business financing, the most common of which are overdraft facilities and credit cards, access which will depend on your trading levels and your bank’s appetite to offer them. Bear in mind that with overdraft facilities in particular you may be asked to provide personal guarantees or even offer up security by way of your, or other directors’ properties as collateral against the debt.
Other types of working capital solutions that are tried and tested are things like inventory financing where you take out a loan or establish a revolving line of credit to finance your stock or invoice financing (sometimes called invoice discounting) whereby you ‘sell’ your debt to a company like MarketFinance who will advance you a percentage of the value of an individual invoice (or potentially your entire debtor book) and charge you interest on the balance until it’s repaid by your customer.
Revenue Based Financing
In today’s digital world and yesterday’s low-interest environment, it’s unsurprising that a number of companies came out to try and provide value to the plethora of eCommerce and SaaS businesses that have continued to flourish – especially during the pandemic where online sales jumped up substantially.
Companies like ClearCo, Out Fund, Uncapped, and PayPal, to name a few, hook into your payment providers such as Stripe, Braintree, or Chargebee to assess your trading volume. They’ll then advance you some cash based on their risk structure and recover it (plus a fee) by taking a cut of your ongoing revenue until the advance has been fully paid. The advantage of this is that if you see a dip in your volumes, your repayments decelerate unlike with a traditional loan which is a fixed monthly payment.
Pipe is driving the way for SaaS businesses to do the same by allowing you to transform recurring revenue into upfront capital.
R&D Credit Financing
Many technology companies in the UK take advantage of the Government’s attractive Research and Development (R&D) tax credit scheme. Via this scheme, you can either offset engrossed R&D expenditure against your corporation tax or, if you are loss-making, claim 14.5% of the engrossed expenditure back as cash.
What many people don’t realise is that there are some companies such as Fundsquire who will advance you a percentage of your anticipated tax credit as an interest-bearing loan with no repayments until the tax credit is approved and paid out by HMRC.
Crowdfunding
Whilst there are a number of equity crowdfunding platforms out there which we may explore in a future post, here we’re talking about the OGs such as Kickstarter and Indiegogo which are platforms that allow you to promote a product or service and solicit preorders. That way, you kill two birds with one stone – gauge the appetite for the product you’ve built and secure the cash (and sales) for your first release.
Loans
A huge number of intermediaries have been established in the UK such as iwoka, Funding Nav, and Swoop providing a marketplace for lenders on one side and businesses looking for financing on the other. Loans range from £1k microloans all the way up to 7 figures.
As with any loan, you need to make sure that you can afford the repayments and do your diligence before taking on any debt.
Summing up
There are a variety of solutions out there that might help you to finance your business without having to source angel or venture capital (and let’s face it, most businesses shouldn’t be looking for that type of funding in the first place) – you just need to work out what makes the most sense for you and your business.
10 bits of VC terminology you need to know
10 bits of VC terminology you need to know
Finance for Growth - Knowledge for Founders
If you’re a first time founder, or even if this isn’t your first rodeo, it can often seem that the startup and venture space is a minefield of insider phrases and acronyms that are like a mason’s secret handshake – only once you’ve been granted that secret knowledge and learned how they work can you get access to the club.
Well, as startup CFOs, we spend a lot of time here at EmergeONE simplifying the complex for the ventures we work with so we thought the least we could do would be to share some of that knowledge here too.
So here we go, 10 bits of VC terminology you need to know.
ARR
Annual Recurring Revenue – this is a metric that is used to infer the future revenue of a business based on its current monthly recurring revenue (MRR). It is calculated by taking the current MRR and multiplying it by 12.
Easy right, so where’s the confusion? The confusion arises because many businesses shouldn’t be using this metric in the first place – it is very much valid for companies that have a recurring revenue model (i.e. SaaS or subscription) – but not if you are running an eCommerce business that relies on one off purchases.
Burn
A company’s Burn is the amount of cash that a company spends during the course of a month in order to keep running. What could be more simple!
But where we see founders tie themselves up in knots is by introducing complexity by qualifying Burn with terms like Gross Burn (Burn excluding cash in from revenue), Net Burn (Burn after taking into account cash from revenue) or Operating Burn (Burn excluding one off, so called, extraordinary items such as say a legal expense or fee paid to a broker for assistance with fundraising). Our advice? Keep it simple, Burn is the net change in your bank account excluding any investment or debt capital that is introduced into the business.
CAC
Customer Acquisition Cost is the average amount of money it costs to bring on one additional customer. Say you spend £1,000 on marketing and bring on 100 new customers, your CAC would be £10. So what’s the catch?
Basically the difficulty isn’t in understanding what it means, rather how to calculate it properly. A company that is serious about understanding how efficiently it is bringing on customers should be able to calculate their CAC per channel (e.g. Google ads vs Instagram vs Viral), only then will they be able to optimise for the best outcome.
Cap Table
The Cap Table (shorthand for capitalisation table) is a summary of a company’s ownership structure, if you want to gain a more in depth understanding, we suggest you read our previous explainer here. Whilst it may seem like an obvious one, we’ve heard founders call it a capex table (capex is shorthand for capital expenditure – i.e. investments in capital items like plant, equipment or property) and we’ve definitely seen them constructed poorly.
Dilution
Founders tend to learn this one pretty quickly but given its importance, it’s worth mentioning here. Dilution is the reduction in an investors’ proportional shareholding as a result of new investment having been taken into the company. For example, at startup, a founder would normally own 100% of the company – let’s say via ownership of 100 shares. Let’s say they then issue a further 25 shares to a new investor. In this instance, the founder has been diluted down by 20% as they now own 100 out of 125 shares which is equivalent to 80%.
Liquidity Event
A liquidity event is typically a milestone in a company’s lifecycle which results in capital being returned to investors. This could be via a sale of the company to a suitable acquirer, a listing on the public stock exchange (an Initial Public Offering or IPO) or even via a secondary round (see below). It is called a liquidity event because private company shares are typically not easy to sell as there isn’t an established market to be able to do this and it is the first time the founders, shareholders or employees receive cash in return for their investment.
LP
Just as a startup has investors, so do venture capital funds. These investors are known as Limited Partners or LPs because they have limited rights within the fund partnership structure. But it’s quite likely that in investing in a particular fund it is because they believe that fund can generate a suitable financial return for them, but also that they will likely invest in startups that fall within a them that the LPs wish to pursue.
LTV
Lifetime Value or LTV is the average value that a customer generates for the business over the lifetime that they interact with the business. For example, if you run an eCommerce business that sells candles for £10 that you purchase for £5 and ship for £1 and customers, on average, purchase 5 candles, you would say that the LTV of a customer is £20.
What many people get wrong is that value is not the same as revenue. In old accounting speak, we would equate value closely with the gross profit a customer drives to the business.
Preferred Shares
When you establish a company, you will normally issue Ordinary shares (in the US this would be called Common Stock) which have fairly standard rights on distribution, winding up and so on. However, as VCs are often deploying more cash and taking more risk, they will only invest in exchange for Preferred Shares. The terms of this class of shares will vary depending on what is agreed with the VC and, in every new round of financing you may end up with different classes of Preferred Shares as new investors come in. This can lead to a fair amount of complexity when the company finally gets to a liquidity event.
Preferred Shares will typically give the investor the right to receive a multiple of their investment back before other shareholders receive anything.
Unit Economics
When VCs talk about unit economics, they are talking about the interplay between a business’ customer Lifetime Value and its acquisition costs and is often expressed as a ratio of x:1 where x describes LTV and 1 describes the CAC. So, for example, if our LTV is £20 and our CAC is £10, our LTV to CAC would be 2:1.
Typically VCs will look for a ratio that converges on 3:1, any less and it may mean that your company can’t scale efficiently (or may destroy value as customers become more costly to acquire) and, any more and it may be that the company could be deploying more cash to grow more quickly.
So there you go, 10 bits of VC terminology you need to know! If there are any terms, or phrases you’d like us to explain or expand on just drop us a comment and we’ll keep updating our list accordingly.
What is a Cap Table?
What is a cap table?
Finance for growth - knowledge for founders
One of the things we are regularly asked to do as startup CFOs here at EmergeONE is to review, fix, model, or even build a company’s cap table. A cap table is fundamental to any growing business – especially one that raises external investment – but many founders and employees don’t appreciate its importance so, in this post, we’re going to go right back to basics and discuss what a cap table even is in the first place.
Cap table is shorthand for the term capitalisation table and at its simplest, it is a record of who owns how many shares in a company – i.e. its ownership structure. From that, one can understand a number of things, including percentage ownership or degree of control.
However, as companies grow, the cap table can become more complex, here’s how.
Employee (or other) options
Options are a financial instrument that gives the holder the right, but not the obligation, to purchase something in the future. Keeping it simple for now, we would normally see options granted to employees, advisors, or others in return for services or as part of their compensation package.
In order to grant options, a company will normally create an options pool from which they will issue them.
Fundamentally, an option means that an option holder can buy ownership in a company in the future without having to outlay any cash right now and often on preferential terms. They can normally exercise (i.e. pay) to convert their options to shares at any point after the option has vested (cleared an artificial time-bound hurdle imposed by the company).
The option pool is ‘added’ to the cap table to reflect this potential change in the future ownership structure.
Warrants
Most startups and scale-ups won’t need to worry about warrants until they are quite advanced and can be considered quite similar to options for our purposes in that like options, they are an instrument that gives the holder the right to purchase a company’s shares at a particular price on a particular date.
Whilst an employee may hold their options all the way through to an exit, because of the time-bound nature of a warrant, once the exercise date passes, the warrant lapses.
Preference shares
As a company scales, it may take on institutional investors like venture capital (VC) firms. Often, these VC firms will not purchase ordinary or common shares, instead, they will buy preference shares. These shares may carry special rights which means that VCs get a multiple of their money back before anyone else if the company exits. This helps them protect their downside.
So, whilst this doesn’t necessarily change the nature of a company’s cap table itself, it creates a challenge when calculating the waterfall distribution of cash when the company exits.
Example
Let’s walk through an example. Let’s say two people, Laura and Sam decide to launch a startup. When they incorporate, they agree that they will each own the same number of shares in their business. Their cap table may look like this:
Shareholder Name | Shares Held | Share Class | % Ownership |
Laura | 100 | Ordinary | 50% |
Sam | 100 | Ordinary | 50% |
Total | 200 | 100% |
Laura and Sam work really hard to create value in their business and are soon able to hire their first employee. Because they have limited cash, they agree that it makes sense to reward employees with share options given they will be paying lower salaries. They agree to create a 20% share option pool in order to allow them to do this. Their cap table now looks like this:
Shareholder Name | Shares Held | Share Class | % Ownership |
Laura | 100 | Ordinary | 40% |
Sam | 100 | Ordinary | 40% |
Option Pool | 50 | Ordinary | 20% |
Total | 250 | 100% |
Note that when we bring options into the mix, we talk about reporting the cap table on a fully diluted basis – i.e. as if all the options have been issued and converted into shares.
Now let’s assume that with the increased capacity and some great milestones under their belt, Laura and Sam go out to secure investment. They talk to a VC fund that agree to acquire a 10% stake in the business on a fully diluted basis (i.e. taking into consideration any options or warrants outstanding) but they agree that in the event of an exit, they will get their investment back first, so Laura and Sam have to create a new class of preferred shares. Their cap table now looks like this:
Shareholder Name | Shares Held | Share Class | % Ownership |
Laura | 100 | Ordinary | 36% |
Sam | 100 | Ordinary | 36% |
Option Pool | 50 | Ordinary | 18% |
VC | 28 | Preferred | 10% |
Total | 278 | 100% |
One thing to note is that when we are going through financing rounds, we don’t usually sell existing shares. Instead, we create new shares to issue to incoming investors. This is why Laura and Sam continue to hold 100 shares each and their shareholding gets diluted down every time they issue new shares.
So there we have it. A cap table helps people interested in a company to understand the ownership structure of the business, a model for future fundraises, do a waterfall analysis of proceeds at exit, and more.
As companies issue more shares during a financing event or create new option pools to incentivize staff, their cap table reflects those changes in the capital structure.
EmergeONE provides finance services for growth companies, and our team regularly gets involved in understanding the cap tables of the businesses we work with, maybe we could help yours too.