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:

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:

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:

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.