What is Cap table?
A capitalization table (generally known as ‘cap table’) usually provides analysis of company’s ownership percentages, equity dilution and value of shares in each round of investment by founders, promoters, investors and other shareholders.
It captures company’s equity shares, preference shares, warrants, compulsory convertible debentures, convertible notes and other convertible equity.
The cap table is mostly required for financial decision making by an entity which involves equity ownership, dilution of existing shareholders due to additional round of investment, market capitalization and market value of the company.
Common mistakes in cap tables
1. Relying on excel spreadsheets
As the company gets the funding and grows it has more and more stakeholders. In those scenarios, relying on excel spreadsheets for managing the cap table can make it disorganized and complicated. Cap tables also need to be updated with every change in the ownership (in scenarios like share transfer, exercising of options, new round of funding, etc) which gets complicated when relied on excel spreadsheets.
Pro Tip
Beneficial to keep the cap table updated
2. Benefits of updating the Cap table at regular intervals
The cap table needs to be updated when any of the below mentioned events occur:
- Raising a new round of investment – Updating the cap table pertaining to the number and class of shares issued to the investors, stake holding of all the shareholders post investment on fully diluted basis, conversion ratio, liquidation preference, valuation of the company at which the new finance round is completed etc.
- Liquidity events – Updating the cap table as when the secondary round is completed to reflect the number of shares transferred, the transferee to be reflected in the cap table, pricing of the shares etc.
- Grant of options to the employees – Details pertaining to the employee to whom the options are granted, number of options granted, vesting schedule, exercise price etc.
- Exercise of options by the employees – This needs to be updated on a real time basis
- Employees leaving the organisation – The cap table needs to be updated pertaining to the unvested options adding to the Employees Stock Option pool and other details.
3. Mismatch in the dates
The date on which the shareholder exercises the option or is allotted the shares and the date mentioned in their share certificate should be the same. In many cap tables, there is a delay between the two dates. This problem can be resolved by using software that allows the company to issue shares electronically.
4. Mismatch in the entity names
Maintaining cap tables in excel generally lead to errors in capturing the basic details like organization/shareholder name (variation in names such as Bright Ventures and Bright Ventures Fund). Shortened titles in cap tables and varying forms of the same entity that do not match the entity’s legal name can cause confusion and lead to varying name in the share certificates. These minor errors are then corrected at the time of due diligence.
5. Incomplete tracking
Generally, the cap tables keep a record of the number of shares held by the shareholders. But it is relevant to keep a record of the stake holding as well of all the shareholders in the company on a fully diluted basis. This will include the different classes of preference shares, compulsory convertible debentures, convertible notes and employee stock option pool.
Pro Tip
Analyze and then negotiate whether carving out option pool has to be at pre-money or post-money valuation of company
6. Negotiating option pool correctly
The stock option pool is generally carved out from the founders’ pool of shares rather than from the investors stake and the same is determined when the company goes for initial round of funding. The size of the pool is generally determined by the investors to be a portion of pre-money (valuation of the company before the funding is received) or post-money (valuation of the company after the funding is received) valuation of the company and the same can be negotiated by the founders. Such negotiations can affect the overall pricing of the company.
7. Founder shares and its vesting period
It is advisable that most of the shares of the founders to get vested over a period of time (say over 4 year) and the same can be decided by the consensus from the founders of the company. The reason is that in case any founder leaves the company before time, then that founder’s unvested shares will lapse. Also, these scenarios have to be built and reflected in the cap table as well.
Pro Tip
Consult lawyers and tax practitioners before structuring a deal and understanding the legal terms
8. Wrong analysis of clauses
Most of the founders of the start-up companies are not familiar with the legal terms used in various legal transaction documents such as participation rights, tag-along rights, liquidation preference, anti-dilution, etc. This can also lead to misinterpretation of these clauses and thereby resulting in an inaccurate cap table.
9. Contact information
As the company grows and has more stakeholders in the cap table, it becomes difficult to retrieve the contact information of the various stakeholders. This makes it difficult for the companies to contact its stakeholders at the time when important event such as liquidity event gets triggers. Therefore, the management spends more time and effort in retrieving that information.
Conclusion
Cap table management is very easy in the initial years of the start-ups when the cap table consists of founders with equity shares and few investors. But, as the start-up grows, it adopts the stock option plans, raises multiple rounds of funding leading to more investors and new share classes on the cap table, employees start exercising the options, triggering anti-dilution clauses, etc. These developments in the cap table increase complexities. All these mistakes are easily avoided with the right tools and proper cap table management.
Authored by Smita Goel, Partner-Tax, and Tanupriya Goyal, Senior Associate-Tax
For any ESOP related query or assistance in structuring, implementing, or managing your ESOP plans, reach out to us at: [email protected]
This material and the information contained herein prepared by Algo Legal is intended to provide general information on a subject or subjects and is not an exhaustive treatment of such subject(s). Algo Legal is not, by means of this material, rendering professional advice or services. The information is not intended to be relied upon as the sole basis for any decision. Algo Legal shall not be responsible for any loss whatsoever sustained by any person who relies on this material.
