When I was first introduced to the concept of cap tables, I drew a parallel with the part of me who has always wanted to try ancestry.com: a cap table is to a business what DNA is to a human being. While I wasn’t too far off, there was still more to learn about this essential business document, and how it’s used to communicate information in business.
Recently, I was lucky enough to connect with James Seely who handles product marketing at eShares, the all-in-one equity management software. He filled me in, graciously answering my questions, and paving the road to this beginner’s guide to understanding cap tables. But not without this recommendation:
“From day one it's really important to think about the cap table. Take the time to get this in order and get some legal help, so it doesn’t get out of hand. Human error happens and the sooner you get a lawyer or law firm involved and implement the right software, the better. This will help you avoid all those little mistakes that you can make along the way.”
- James Seely, Product Marketing at eShares
What your cap table says about your business (Hint: it’s a lot)
At a high level, the cap table is a spreadsheet businesses use to track who owns what percentage of a company. For example, at the very early stage, if two people decided to start a coffee shop, they would each own fifty percent. At this point, the cap table is very simple. So simple the owners could pretty much draw it on a napkin.
As that coffee shop grows, they’ll hire employees and bring in new investors. These additions will take their own chunk of the pie which is when that napkin can get complicated quickly, and it becomes time to create a formal cap table. This is usually done in Excel.
Anatomy of a cap table:
Cap tables can include different details for each company, but each one is composed of the same essential things:
- Who has invested in the company
- How much they’ve invested (at what price)
- How many shares they own (what their ownership percentage is)
- How that ownership percentage translates (or will translate) into actual equity (what it is worth after being fully diluted)
Based on this information and the tracking performed at the transactional level, you can see the percentages and values of equity at each funding round and how the value of the company’s equity increases between each transaction.
Who manages your cap table?
While you’ll primarily use your cap table as a reference point, it’s hardly an at-a-glance document. Think of it more like a living record of your company’s significant equity transactions, shareholder information, and regulations that gets updated each time there is an equity transaction. Needless to say managing a cap table can get more complex than merely adding lines to a spreadsheet.
You may think because a cap table usually gets presented in a spreadsheet that an accountant or CPA is the one managing it. But actually an accountant will not be the one to create or manage your cap table, you will (with a little help from someone with a law degree).
While ideally, you should involve a law firm from day one, the cap table management role depends on the size of the company. At the earlier stages it's generally the founders and, in many cases, the seed round is where a legal specialist or team gets brought in.
Really, anything having to do with someone giving you money for a stake or your company equity (investor relations and stockholder negotiations) will undoubtedly require a legal document outlining the terms of that agreement. A lawyer will be the one who creates these official documents to denote how much each person owns, or the amount of money they’ve given you and how much it will be worth down the road. Then they help you update your cap table accordingly with the terms of the agreement.
Many smaller companies will have at least one legal contact from the very beginning but might switch law firms as they grow. This change causes a bit of back and forth between different law firms before things are settled. During that transition period, the founders are responsible for tracking everything. As the company grows and approaches their series A or B, a controller or CFO typically comes in to manage the entire process internally along with a full-time, in-house attorney.
How business owners and investors use a cap table
While you may not use it every day or every week, if you’re starting or running a business your cap table will be one of your most trusted guiding lights when it comes to making decisions in your investors’ best interests as well as your own as a founder. Here the main times you’ll want to refer to your cap table:
- When raising funding, a well-organized cap table is an integral part of investor and employee negotiations. Investors will want to see the existing capital structure of the company and where they will fit in, while founders will forecast how new investments will dilute ownership percentages and value of each share.
- When issuing stock options to employees can make managing a cap table pretty complex, but even more useful. This is where you’ll need to track how many shares of stock have vested over time and make adjustments when an employee option holder leaves a company along with restricted stocks, transfers, and repurchases. Clearly, it’s tricky.
- When hiring for major roles as well as holding onto key role players who have been an important part of your team, equity can be a compelling deciding factor. And not just your executive team, but more employees are looking for equity as a part of compensation and being transparent with your cap table is a great way to negotiate. Your talent or HR team will thank you!
- When laying out your exit strategy, your cap table is what you’ll use to determine who gets what when you go public or get acquired if/when the time comes.
More on how to use cap tables in the investment process:
In terms of milestones in the life of a company, fundraising is one of the most critical times that the cap table comes into play. This is for a couple of different reasons, but ultimately it's because those investors need to see that everything has been tracked correctly up until that point.
If you’ve kept your records manually, say in Excel and not in specialized software, this gets pretty expensive. A law firm must go through the documents by hand and make sure everything has been reconciled and kept up-to-date which equates to substantial billable hours.
At that point whenever there's a round of funding, the cap table is used to model out the new round, so they need to see how much money is coming in and how the dilution might look. During an investment round, There's generally a lot of negotiation that takes place around the valuation of the company.
From the investor perspective, the cap table gives them a point of reference for the existing capital structure of the company and allows them to see where they're going to fit into that. From the present owner’s or shareholder’s perspective, they can use the cap table to determine how much percentage they are giving the new investors for the amount of money they're contributing. So that becomes the basis for negotiating:
- What is the accurate valuation of the company?
- How much are the shareholders and new investors getting?
- What is the price of the new stock going to be?
You can see this exchange go down in any given episode of Shark Tank. The business owner comes in seeking a target investment amount for a specific percentage or portion of equity in the business. Those measures originate in the valuation of the company—which is based on a mixture of things but is ultimately traceable in the cap table. Usually, there’s a conflict of interest because the founders want the valuation to be higher, but the investors want it to be lower because that means they're paying less for a bigger chunk of the company. So when you think about it, the cap table is the source of the show’s most pivotal, dramatic moments.
How an accountant uses your cap table
Accountants and auditors come in to help manage interrelated formalities such as compliance. During series A and B rounds, companies start issuing stock compensation expense reporting as they issue equity to employees and track it on their books.
Whether your business is a corporation, proprietorship, or partnership, an outsourced accounting provider will need to know your ownership distribution. This helps them thoroughly understand who the stakeholders are and how to allocate your profits and losses accordingly. From there an accountant can set up the owner’s equity section of your balance sheet accordingly and use the amount of shares and the dates they were allocated to create proper journal entries in your books.
If you’ve incorporated as a corporation, an accountant will use your cap table to understand the ownership distribution, stock agreements, and forms of equity so they can set up the owner’s equity section of your balance sheet accordingly. They’ll also need the number of shares and the dates they were allocated to create proper journal entries in your books.
If your business isn’t a corporation but does have multiple stakeholders, like an LLC or other type of entity partnership, an accountant will use an Operating Agreement instead of a cap table to determine the percentage of ownership and allocate and distribute profits and losses. Just like a cap table is always changing, when an LLC adds a new partner you will amend or rewrite your operating agreement.
Using a cap table to prepare your business taxes
Having the cap table and knowing the ownership equity or the partnership equity also helps tax preparers identify tax responsibilities. A common point of concern when filing business taxes are international tax responsibilities. The cap table will tell a tax preparer which forms a business is required to file or issue to their stakeholders.
Using a cap table to identify your income tax filing requirements:
As we’ve said before, the IRS is dead serious about tracking all income, and equity is no exception. The main thing a tax expert uses a cap table for is disclosures. In many circumstances, if you own 25% or more of any entity you are required to disclose it. This becomes especially important when you have foreign activities. Your tax specialist can use your cap table to determine what foreign filing obligations your shareholders need to be aware of to avoid pricey tax penalties (upwards of $10,000 per late/incomplete filing).
There are also tax concerns when employees exercise their incentive stock options. When this happens, corporations are required to file Form 3921 to inform tax authorities that they’ve transferred company stock to a shareholder.
Aside from the IRS, here are other tax-related scenarios where your cap table is concerned:
- If you’re incorporated in Delaware, which many businesses do to save on corporate income taxes, you are required to file and pay a franchise tax. This filing process requires an up to date cap table.
- If you’re the founding member of a company, you’ll want to talk to your tax expert about the 83(b) election. Using the 83(b) election means that if your stock explodes in value, you and your co-founders won’t have to pay an annual tax on it unless the company is later bought, merged, or goes public because you will pay up front.
Thinking about a new accounting solution? What to include with your cap table when making the switch:
Now that you know how an outsourced accountant, like inDinero, uses your Cap Table or Ownership Agreement, download your copy of the Getting Started with inDinero Checklist to know the rest of the documents you can supply to provide the most comprehensive view of your business’s finances when making your switch.