What Is the Cap Table & Why Is It Important?
Last updated on March 4, 2023 by
A Review for Biotech Startup Founders
Being a biotech or biopharma startup founder comes with a huge list of responsibilities. Many of which pertain to the lab. However, several of those responsibilities fall outside of the laboratory and concern finance. One of those responsibilities is fundraising, and everything that comes with it.
Founders in the life sciences have turned to venture capital, seed, and angel investors —generally some of the first funding options available to startups—time and time again to secure much-needed capital for funding operations, including scaling lab research. To get these investors involved, you have to sell shares in the company. The process of selling shares in exchange for capital is referred to as equity financing, because your shares are a type of equity.
Equity financing—you might hear the term venture capital financing thrown around as well—is particularly relevant to the life sciences due to the industry’s capital-intensive nature. It’s costly to discover and develop a drug.
R&D is extensive, and taking an NME through preclinical studies, costly clinical trials, and an FDA filing often takes millions of dollars. It is millions of dollars that many small biotech founders don’t have on hand. Grants, loans, crowdfunding, and bootstrapping don’t always provide founders with enough cash to effectively develop a product and scale operations. Plus, it can take several years or more to generate any kind of revenue.
Because so much capital is needed in the life sciences industry, you will likely raise several equity-based rounds. While it’s easy to record the equity split between a founding team, it can become much more difficult to accurately record and track equity distribution as you bring on investors and raise consecutive rounds.
To keep track of who owns how much of your company, founders create a cap table, short for capitalization table. Managing this document becomes a critical task and can eventually get pretty complex with enough investor activity and hiring. This article will review what a cap table is, who creates it, how it works, and how to manage one.
What is a Cap Table?
Before we begin, let’s define equity. Equity, in business, represents the value of ownership, ownership of assets that may or may not have liabilities attached to them. Someone who owns a portion of a company owns equity in the business.
If they own equity in the business, they’re considered a shareholder. And as a shareholder, they have what’s called shareholder equity, or stockholder equity. They have ownership in the business and a “residual claim on assets after debts have been paid.” They may also have rights to benefits paid over time as the company operates, called dividends.
Investors aren’t the only types of shareholders. Founders and employees are considered shareholders as well if they own shares in the company.
Keep in mind that some companies offer a promise of future shares, delivered later in time, to incentivize new employees or to compensate for modest salaries. Promises of future shares come in many other forms, including convertible debt, options and warrants.
The capitalization table breaks down and tracks the distribution of a company’s shareholders’ equity. This chart acts as a tool and record by listing out and tracking several essential aspects of a company and its ownership, including:
- Name of all shareholders
- Number of shares owned by each shareholder
- Percentage of ownership held in the company
- Equity dilution
- Change in value of equity after each funding round
Simply put, a cap table shows who owns how much of the company at any given time.
Furthermore, a company’s equity is issued in the form of a security. Equity can come in different flavors. All of your company’s securities that have been issued, as well as who owns them, are visible on the cap table. These securities include:
- Convertible notes
- Stock Options
- Equity grants
For startups, the cap table is a fundamental document that helps you stay up-to-date with the details of your startup’s equity at every stage of growth. Furthermore, it helps you and your investors model and analyze events such as ownership dilution, issuing employee stock options, or issuing new securities.
For example, founders can use the cap table to determine the percentage of shares already traded and held by employees and investors. This shows the extent of dilution in the business and helps founders strategize around the possibilities of dilution, as well as the impact it will have on existing shareholders.
The cap table is straightforward and can be maintained as a simple spreadsheet. However, it becomes more complex to manage as your business grows. The more investment rounds or other significant financial changes on the table, the more complex the document can get.
To illustrate how a cap table evolves, let’s consider the adding of investors via funding round and the consequent events that are reflected in the cap table:
- Incorporation by the founders: this is when the cap table will be at its simplest. It typically shows the split of equity between the founders of the company and its first few employees.
- Seed round raised: This introduces one or more investors to the table who now own a portion of the company after investing in the startup in exchange for equity. Their investment alters the overall value of the startup.
- Options pool created: When options are provided for new employees, the value and breakdown of the company changes, as represented by the cap table. Over time, as more employees are hired, and more options are granted, the cap table becomes more complex.
- VC rounds raised: When the startup takes on any additional venture capital funding rounds taken on by the startup, the valuation drastically changes, as does the list of stakeholders on the cap table, adding a new layer of complexity. Keeping track of who owns what and how much of it becomes essential.
These events or rounds are significant and change the breakdown and complexity of the cap table. Equity distribution software can often take the place of spreadsheets at these later stages. It can help you manage your cap table and related documents as your capital structure grows in complexity.
It’s recommended that you start using cap table management software initially, especially if you plan to raise equity capital. When it’s just you and your co-founders, keeping track of equity is simple in the very early days. (It can help to compare management software before you commit to one.)
However, the minute you begin raising capital from investors, things can get unwieldy quickly. Putting software in place that can accurately track the equity distribution of your startup and automate many of those processes is invaluable, saving you time and minimizing mistakes.
What Does a Cap Table Look Like?
There is no one way to format a cap table. Depending on your need for details, it can be simple or in-depth.
The base requirements of a cap table include a list of founders, investors, and common shareholders along a y-axis and the details surrounding what each person or group owns (preferred shares, common shares, etc.) along an x-axis. Details beyond these buckets vary from startup to startup. But, the requirements illustrate the basic outline of what a cap table should look like and include.
For example, according to Fred Wilson, a simple cap table should show all the major stockholders of the company.
(I’ve been referring to stockholders as shareholders, which are interchangeable terms. However, you can dive a little deeper into their differences if you’d like.)
It should also show the major option holders and buckets of option holders.
Furthermore, it should show all of the classes of stock and how much was paid for them, and for each investor, it should show how much of each class was bought and how many shares of that class they own as a result.
Using this data, you can total up the cost and shares and then calculate ownerships on a fully-diluted basis (this means you include the options, regardless of whether they are issued or vested). Fred Wilson enjoys this simple cap table because of its simplicity, and because it “shows the progression of financing activity.” It also has the “benefit of showing how much each investor has put in on a cost basis, which many cap tables leave out.”
Here’s a cap table template example from CFI (Fred Wilson’s template is great too):
Source: Corporate Finance Institute. Cap Table Template
Why Is a Cap Table Important for Startups?
Cap tables are important for startups for a variety of reasons. Not only are they a procedural necessity, but they also help stakeholders plan for the future. Founders and their investors can keep track of company ownership breakdown, its value over time, the potential dilution stakeholders will experience in any subsequent funding rounds, and more.
Let’s look at some of the key benefits founders can experience when using a cap table.
As mentioned, it’s important that you’re aware of who owns how much of your company. The cap tables tell you and your investors the exact details of what you own, what they own, and what any other investors own. Knowing these details helps you forecast potential payouts and dilution under specific scenarios based on the ownership split. The breakdown of ownership in a startup can affect the company’s value for future fundraising rounds and who needs to be at the table for certain critical company decisions.
Your investors can use the cap table to predict ownership dilution for different outcomes on their investments. Furthermore, potential investors and your future fundraising can be affected by the cap table. By viewing your cap table, these potential investors can evaluate how much control and leverage could be maintained during negotiations.
Additionally, depending on the historical information available in your cap table, you can use it to negotiate the current valuation for new funding rounds. Lastly, existing shareholders can easily use the cap table to determine what percentage of the company would be ideal to give to the new investors in exchange for the capital contributed.
Keep Track of Value In Real-Time
Having an up-to-date and detailed cap table can help you track the value of your startup over time. Beyond providing your current investors and co-founders with an understanding of your startup’s growing value, employee-shareholders find the cap table useful as well.
That’s because, in certain situations, employees who have options or equity stakes in the company can access the cap table if they have options or equity stakes. They can see how their ownership percentage breaks down. Offering equity is an appealing way to draw top talent at leading startups. The ability to track value in real-time via the cap table shouldn’t be overlooked.
Prepare for Potential Audits or Other Financial Situations
The cap table is helpful outside of ownership breakdown and equity distribution. In the event of an audit, your cap table can help your legal team to present your company’s history and holdings with accurate and organized information. This example illustrates the importance of maintaining a well-organized cap table, as it is critical to the health and growth of a company in almost any financial situation.
How to Create Your Cap Table
Creating and managing a cap table is not an easy task. You can create it manually initially, but as the business expands and you add new stakeholders, keeping track of all vesting schedules and attending to every stakeholder’s need becomes an elaborate process, one that is prone to manual errors. Let’s take a look at the two basic methods of cap table management:
Creating a cap table using Microsoft Excel is perhaps the most common approach for startups. Many good templates exist for free. Excel is relatively easy to use, and setting up a cap table using this software takes no time at all.
It can be as simple as a few lines regarding who owns how much in the company, or it can be as detailed as you like, showing exactly what is owned by who and how many outstanding shares are issued.
In the very beginning, maintaining your cap table in Excel is straightforward because the company is owned by a few people. The amount of equity information that needs to be tracked is low.
While using Excel provides the flexibility to customize a simple cap table as per the company’s needs, the complexity of the cap table can change dramatically as consecutive rounds of investments are secured and employee hires are made that include providing employees with equity. As each round is raised, dilution occurs, and manually updating these fluctuations in equity ownership becomes a complex task.
Many startups can forgo the use of cap table management software because their cap table does not go through significant changes quickly. However, the software can become a much more sensible option when things do get complicated. Before exploring software, consider the pros and cons of using Excel to structure and manage your cap table:
- Quick and easy to set up
- Highly customizable, fitting to your exact needs at the time
- Relatively inexpensive software
- Manually tracking, maintaining, and updating your cap table as the number of stakeholders (with their various ownership percentages and vesting periods) grows is cumbersome and can lead to expensive errors.
- Errors in the cap table can negatively impact your chances of securing future funds. When equity distribution isn’t properly tracked, it affects your valuation, affecting the investment offers.
- Consolidating all versions of your cap table and the information listed to suit IRS and SEC regulations can be challenging without the proper software.
Using Cap Table Software
Cap table software can provide ease-of-use that Excel cannot, specifically when you’re experiencing significant investor activity. The various software available today are designed by companies specializing in equity management and aim to consolidate best practices across all stages of business and diverse industries.
As mentioned, it’s often recommended to use cap table software right away to streamline all equity management efforts. Cap table software offers several benefits to its users, including:
- Streamlines workflows on grants, approvals
- Monitors all forms of equity: options, stocks, warrants, convertible notes, etc.
- Manages financing rounds, employee equity incentive plans, and options pool
- Creates audit-ready reports, saving on bookkeeping costs
- Facilitates finance modelings: waterfall analysis and round modeling
- Integrates multiple functions: payroll systems, accounting records, collection and distribution of stock purchase payments, and relevant legal documents
Although cap table management software offers robust features and ease of use, it may not be necessary for your company. While cap table management is critical, you may not have enough investor activity to warrant the use of a management software package. Weigh your needs and review your fundraising strategy to determine whether or not you’ll need to invest in cap table management software.
Why Managing Your Cap Table is Important
There are five key benefits to effectively managing your cap table. These include increasing your chances of raising money on better terms, making it easier to track and issue options, hiring key employees, selling the company, and more. Let’s take a quick look.
You Can Raise Money on Better Terms
Modeling new financing rounds and analyzing the impact on shareholders will be vital in negotiating with investors and maintaining a meaningful stake for founders and employees. Your cap table will be at the center of these negotiations.
If you have an organized cap table from the start, you’re much less likely to make costly mistakes when it comes time to raise capital.
Track & Issue Options More Easily
Tracking your equity holdings sounds easy in principle. In reality, it can get complicated as you raise more funding rounds.
Existing stock options typically vest over time, so you need to track how many shares have vested for every option grant. If an option holder leaves the company, their unvested options are forfeited, and they have a set amount of time to exercise any vested options before they are also lost.
To make matters more complicated, you will also need to keep track of early exercises, restricted stock, transfers, and repurchases. Additionally, all your option expense activity will need to be accounted for on your financial statements under ASC 718 stock expense requirements.
Hire Key Employees
Your cap table can even help with talent recruitment and retention. We know that equity is vital for hiring and retaining employees at startups. Shareholders, particularly executives you hire in the beginning, may want to know their payout at various exit values if the company sells.
Because of this and the competitive nature of startups, more and more companies are choosing to be transparent about their cap table with all of their employee hires, not just investors, executives, and employee option holders. Doing so can be an effective morale booster, incentivizing employees to focus on the company’s long-term growth when their compensation may not be as competitive as a position with another company.
A significant part of cap table management is tax and regulatory compliance. The IRS has a lot to say regarding the taxation of equity, so you need to make sure you’re doing things correctly.
An incorrect or misrepresented cap table can lead to the company or employees paying tax penalties. To help you start off on the right foot, here’s a list of some of the most common regulations you should be aware of that involve the cap table:
- ISO 100k: This ISO’s limits stipulate how many options vest in a given calendar year to qualify for particular tax treatment.
- IRC 409A: These regulations require you to do a formal valuation at least once a year to determine an appropriate strike price for options.
- ASC 718 (formerly FAS 123R): This accounting requirement measures and records the expense associated with issuing equity-based compensation.
- Rule 701: This rule is an exemption from being required to register with the SEC to issue equity compensation.
- 83(b) election: pertains to the tax treatment of restricted stock awards, and it needs to be filed within 30 days of grant.
Increase Your Chances of Selling the Company
If you plan on selling your business or going public through an initial public offering (IPO), your cap table will be a critical part of understanding how your equity holders will be paid out.
For example, if you’re acquired, the acquiring company will likely bring in a team of lawyers to examine your cap table. They’ll look at all of your shareholder agreements, option agreements, and sale agreements as well to ensure that the information provided is accurate.
Any disparate or conflicting information can potentially delay the sale process or result in legal disputes. When you’re trying to sell your business, the last thing you want on your hands is a lawsuit or a lengthy due diligence exercise.
Creating and maintaining a cap table is essential when starting a company. It’s even more critical when you start fundraising.
Without one, it can be challenging to keep track of who owns how much of your company at any given moment, which is especially important when you’re raising multiple rounds and experiencing significant investor activity.
Whether you decide to use a spreadsheet or cap table management software, it’s essential that you accurately list your equity distribution. An inaccurate cap table can lead to expensive mistakes and serious issues when raising money in the future.
This article is purely informative and is not meant to represent legal advice. Before creating a budget plan, it is best practice to speak with a financial expert.