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What is a Cap Table? 🧐 Tracking VC Investments and stock option grants - YouTube

Channel: Feel the Boot

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I have found that a lot of founders are confused about the way equity works

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in startups and how to track ownership in cap tables.

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And that's not too surprising,

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because it's really extremely different to the way regular stock markets work.

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So today I want to give you an overview

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of how capitalization and equity ownership works in startups so that you can talk

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intelligently to your lawyers, investors, co-founders, and new hires.

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But the most important piece of advice I'll give right now.

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Always make sure to get everything you do reviewed by a lawyer.

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Mistakes on your cap table are some

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of the worst you can possibly make and go bad in terrible ways.

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Greetings, founders.

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Welcome to Feel the Boot, the Science of Startups.

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I'm your host, Lance Cottrell,

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and I'm here to help you along the arduous journey of launching your startup and help

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you climb the vertical learning curve that you're going to encounter along the way.

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I know, I've been there myself,

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and I have helped countless other founders along their journeys.

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So let's start with the big picture.

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Stock represents ownership in a company,

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so each share of stock is one small slice of the pie of the whole company.

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Now, unlike normal stock where you're buying and selling on the stock market,

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you're typically not trading with another person who owns it.

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Rather, you're creating stock from nothing

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and the company's selling that stock to the investors.

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And often you're creating different flavors of stock.

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That's called series.

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So you'll have Series C, Series A, Series B.

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So each time you do an investment round, you typically will create a new kind

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of stock, each one of which needs to be tracked separately.

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The only stock that exists at the very beginning, and is created when your

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business is incorporated, is the common stock.

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Now, when you're thinking about your

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company's stock, any given share can exist in sort of four different states:

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authorized, issued, outstanding, and reserved.

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So the authorized stock is the amount of stock, the number of shares of each

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type, that the company is authorized to issue.

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The maximum it can possibly hand out

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that's actually written down in the articles of incorporation.

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And when you want to issue more stock than is authorized, you are actually amending

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the articles of incorporation to allow you to create that new stock.

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The next category is issued stock.

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So of the shares that you are authorized

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to issue, you may not have in fact, handed out all of them.

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So the number that you've issued is the number that are owned by someone,

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either an investor, an employee, you, or indeed, even the company.

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If the company has done a stock buyback.

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Outstanding, is all the stock owned by people who aren't the company itself.

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So all the stock you've issued to anyone

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except the stock that the company itself owns because of a buyback.

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And finally, there's reserved shares.

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These are shares that have not been given to anyone.

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But they're being held back in a kind

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of almost escrow account against some future obligation.

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The most common of these is your options pool.

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You have the ability

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to issue all of these options, and at any point any employee could

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exercise their options and turn it into stock.

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And you need to guarantee that stock exists.

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And so an options pool or other reserved

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pool of stock makes sure that the shares are there when called on.

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The differences between common

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and preferred stock really deserve their entire own episode.

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But in the context of this episode, I wanted to give just a Cliff Notes

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version explaining the difference between them.

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So common stock is typically most of the shares that you're going to issue.

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It is the kind of shares that you're trading on the stock exchanges primarily.

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It has no liquidation preferences and no other special voting rights.

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It's the vanilla kind of stock.

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But when you start bringing in investors,

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they're looking for some protection of their investment,

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and they will negotiate other special terms for their series of stock.

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And these terms may vary in each series you release.

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So the people who bought in on your C round will negotiate one set of things.

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But maybe you're over a barrel a little bit when you're doing your A round,

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they're able to extract more concessions from you.

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And then let's say you're really killing it when you get to your B round,

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and therefore you have to give away fewer rights to them.

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The biggest difference between common

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and preferred shares is the preference, and this is an amount of money paid back

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to the shareholders before anyone else gets paid.

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And this comes in two flavors.

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So there's participating preferred and non participating preferred.

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And typically it's expressed as a multiple of the initial investment.

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So most commonly you'll see one times

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preferred stock, but sometimes you'll see two or three.

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And what that means is how many times the investor's initial investment they get

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back before you start distributing money to everyone else.

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Now participating preferred: when your

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company is sold or acquired, liquidated in some way,

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the participating preferred get their preference back their initial investment

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twice their investment three times their investment.

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And then they get to convert into common stock and get all of their fair share

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of the common stock based on how many shares they convert into.

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Whereas non-participating stock gives them a choice.

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They can either take their

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preference, some multiple of their investment, or they can turn into common

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stock and participate along with everyone else.

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And that's much more fair because it's

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a little bit of double dipping when you have fully participating preferred stocks.

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So try to avoid that if you at all can.

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In general, with non-participating

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preferred, the investor will only take that option if bad things have happened.

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The company is getting sold at a fire

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sale, the value is down from where the person came in,

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in which case all of the proceeds are going to go to the preferred holders,

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leaving basically nothing on the table for the common stock.

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But that's the way the cookie crumbles in a bad outcome.

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In the US, most investors demand preferred shares because they want that extra level

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of protection and to be able to recoup some of their losses if things go bad.

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But that's not universal.

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And in other countries, for example, the UK, there are tax incentives that make

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it very strongly preferred to get common stock in pre-seed rounds because

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the government has given out all kinds of interesting incentives.

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So what kind of stock and what kind

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of terms may vary depending on your local laws and tax codes.

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Now, one term that you're likely to run into as soon as you start working

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with investors is the term fully diluted shares.

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And that's often the number that's used

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to calculate the per share price of your company.

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And all it means is the number of shares that you would have outstanding if

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everyone exercised all of the contingencies they have.

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So the board issued every option in your options pool, and then every employee

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exercised all of those options, and every warrant holder exercise their warrants.

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Every possible bit of potential stock gets

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turned into real stock, and that gets counted up.

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And that's the fully diluted number

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of shares, the maximum number that could happen in a foreseeable outcome.

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Interestingly, it doesn't include things like safes or convertible notes,

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because you don't actually know how many those would turn into.

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Those don't actually turn into a fixed

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number of shares until there's a conversion event and you know what

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the next investment is, what that per share price is,

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and then that locks the actual number of shares being given out.

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So those are things that are important

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to track alongside the cap table, maybe in a different section of the cap table.

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They don't go in the main section of shares, but still,

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it's important information for an investor or even a new hire to be able to see

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to understand the context of the rest of the cap table.

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I want to pause for a moment here

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in the middle of the episode and ask you for a favor.

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If you're enjoying this episode, please give it a like.

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It tells YouTube that this is the kind of content you want to see more of.

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If you've watched a number of these episodes, I'd like you to subscribe

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It makes an enormous difference to the channel.

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While you're at it, leave a comment.

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Let me know what other kinds of content you'd like to see covered in this channel.

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Thanks.

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Another thing that you need to be tracking alongside your cap table,

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but not actually on the cap table itself, is your option grants.

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As soon as you start handing out stock options to your employees,

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you need to be recording who received them, how many options did they get?

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What date were they issued on?

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What's the strike price of those options?

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What's the vesting schedule for those

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options, and what is the expiration date of those options?

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Very important to always have all

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of that information on hand, up to date and accurate.

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Now, keeping track of all this and doing it correctly can get pretty complicated.

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There's a lot of spreadsheet templates out

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there that you can download, but I don't recommend them.

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You should use an online tool to track your cap table.

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It takes care of all the calculations

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and make sure that you don't accidentally fat finger something into the tool or

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misenter one of the formulas or some mistake like that.

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I'm not going to give a specific

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recommendation because tools are evolving and new ones appearing all the time.

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So you're going to want to do some quick

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searching to look for and choose a good, reliable cap table management solution.

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There are lots of good ones out there, and it's really important to get this right.

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You need to have all of this information

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tracked and accurate, and you need to make sure that you're kept

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up on your record keeping, including the contract.

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You need to quickly be able to lay hands

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on every single Shareholder Agreement and Subscription Agreement Option Grant

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Board vote to issue those grants Shareholder votes to authorize shares.

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All of that needs to be easy at hand

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for due diligence and to settle any disputes that may arise.

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Because when disputes arise over

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the percentage ownership of the company, it is really nasty.

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And if there's any sort of question marks

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around that ownership, it will scare off your investors.

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They will run for a mile at the first

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whiff of hinkiness in your cap table, so make sure that is super buttoned up.

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Also, even with a tool,

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make sure you're getting everything double checked by a lawyer.

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Having that second pair of eyes can really

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help with the accuracy of what you're doing.

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Plus, it demonstrates good faith and best

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efforts in trying to maintain accurate records.

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Let's examine what your cap table looks

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like at a couple of different points in the evolution of your company,

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starting with right after you actually incorporate it.

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This is the simplest your cap table will ever be.

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Fundamentally, there's only going to be

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an entry for each one of the founders with your respective number of shares.

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Now, as you can see here, what we've done is authorized 10 million shares.

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So when we created the company, we wrote into the articles

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of incorporation we can issue up to 10 million shares total,

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but at the moment we've only issued 5 million shares of common stock.

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3 million went to the first founder and 2

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million went to the co founder because that's what they agreed on.

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All of this is arbitrary.

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You can pick any numbers you want, but now you've got the ownership.

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One of them owns 60%, the other owns 40%.

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That represents everything.

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All the rest of the stock is unissued.

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Now, let's fast forward, let's say a year, and you've made some progress.

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You've hired some employees, and you've brought in some early angel investors.

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And those Angels have invested through

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a convertible note ,they could have easily done so with a safe as well.

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And you have also hired some employees.

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So you created an options pool and have issued some options out of it.

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So now you have issued 6 million shares of common stock because you created a 1

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million share option pool just out of thin air.

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The board and the shareholders authorize doing that.

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And so far, you've granted 4000 options to your early hires.

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And then these two Angels have brought in some cash.

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One of them invested, say, $100,000 and the other $50,000.

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There's going to be some interest rate, and they've got a cap.

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This is going to be capped at a $5 million

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valuation, so they're never going to convert at worse than $5 million.

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But if the next person came in low,

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they would be converting at, say, a 20% discount to whatever that person gets.

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So the main cap table shows the actual shares issued.

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And then alongside that,

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you have another table showing the investors in these convertible

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instruments so that the next person who comes along can sort of see where all

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the ownership is going to go, even though those people don't have shares yet.

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A year later, you've closed your A round.

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So now you have a VC on the cap table who has negotiated a deal for your first

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series of stock, in this case, your series A.

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Although it could easily have been Series C.

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The names don't actually mean anything in the process.

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Both of the earlier angel investors have

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converted, and they also get that series A stock.

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So now you have two kinds of stock.

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And in the process of this,

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your shareholders have authorized the creation of this pool of series A stock.

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And so let's say they've authorized a million and a half shares, but in fact,

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you're only issuing a million 380 some out to those shareholders.

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You've now issued some more options.

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So maybe you've got 600,000 options out to your employees.

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So your pool is now down to 400k.

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And in fact, that might be getting a little small.

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Your series A investors might have

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requested that you increase the size of your option pool by this time.

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But for this simple example, we're going to ignore that complexity.

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All of those convertible notes have converted, so we no longer have

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that section on the table, although you're likely to be bringing

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in some sort of bridge round in the near future.

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And so those will show up on the side again at that point.

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And each time you issue a new series,

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you'll get a new column here of a new kind of stock.

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And when we're looking at the ownership

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again, that's always calculated against the fully diluted number.

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So that's all the issued shares of common stock, the entire options pool granted

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and not granted, and all of the series A shares, all of that gets added together.

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Typically, for simplicity,

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your preferred stock and your common stock are one to one.

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They vote with the same power and they convert into each other at one to one.

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There are times if there's stock splits,

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or someone had an anti-dilution provisions, it can change that.

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That'll make the cap table messier

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but still, fundamentally, there is some ratio.

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And when you're talking about fully

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diluted shares, it's always as if everything converted

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to common and we just count up all the common shares.

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Now, all of this was really just a very

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high level overview of how equity and cap tables work in startups,

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just enough to help you be able to speak intelligently to investors, lawyers,

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employees, cofounders, and everyone else who's going to be

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concerned about how the pie of your company is getting divided up.

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Now, my advice still stands.

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I strongly encourage you to go out and use a tool to actually track all of this.

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Be diligent in keeping up to date

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and maintaining all of the documentation of every single change made in any way

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to any of these cap table documents and have your lawyer review it.

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I just can't jump up and down about that enough.

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It is disastrous if there's a fight over your cap table.

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Thanks for watching this episode.

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I hope you found it useful and interesting.

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And if you did, do the usual, like subscribe ring the Bell.

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