Cap Table Basics: Formation to Early Stage Funding

These highlights are from the “Cap Table Basics: Formation to Early Stage Funding” Startup Fundamentals webinar presented on May 22, 2024 by Kelly Siobhan Laffey and Durdana Karim of Stubbs Alderton & Markiles, LLP. The on-demand version is available on the WFN website here. The webinar covered the components of a cap table, including:

ownership and rights to acquire ownership, how cap tables are used, how dilution works, and retaining ownership at formation and in a financing.

Components of a Cap Table

A Cap (Capitalization) Table tells you who owns what:

Ownership, and rights to acquire ownership, specifically:

• Shares of stock

• The option pool, if any

• Issued options and warrants

• Convertible notes or SAFEs (typically in comments since exact ownership is not known before conversion)
  

Calculation of Ownership

Authorized vs. Issued Shares – Authorized share counts do not affect ownership calculations

Issued and Outstanding vs. Fully Diluted

• Outstanding: actual issued stock or units, i.e., not options, notes, warrants, etc. This is useful for purposes, for instance, of calculating voting rights at a given point in time.

• Fully diluted: assumes convertible or exercisable securities are converted or exercised, and that the full option pool gets issued. This is typically what investors look at; when modeling their investment ownership, they will assume contingent securities get converted or exercised.

Option Pools

• Size: Typically ranges from 5-25% of fully diluted capitalization depending on stage of the company and company’s equity compensation practice

• Differences vs. shares of stock: Unless and until exercised (at which point an option becomes shares), an option represents only the right to purchase shares at a specified price (e.g., no voting rights)

• Practice point: Formalities matter especially for option grants. Get a board consent with a fair market value determination by the board in place for every grant at the time of issuance.

How Cap Tables Are Used

• Raising Funds

• Hiring and Retaining Workers

• Tax and Regulation Compliance

• Selling the Company

How Dilution Works

Dilution is the decrease in ownership % for existing shareholders that occurs when a corporation issues new shares. Absent a written agreement to the contrary, any newly issued equity decreases everyone’s % ownership proportionately. In the usual course of a growing business, this tends to be “good dilution” – a smaller piece of a bigger pie.

Example of Dilution: Pre- and Post-Funding Founder Percentages

XYZ, Inc. is valued at $1M, and an investor writes a check for $200k. Investor gets 16.67% of the company, because her $200k gets added to the $1M as company value when invested, $200k/$1.2M=16.67%.

The % ownership decreased for each holder, but the dollar value of their respective portions is the same pre- and post-funding, since each owns a proportionately reduced smaller piece of a bigger (i.e., higher value) pie.

Pro Forma Cap Table

Projected cap table showing ownership structure pre- and post-transactional activity, such as a funding round, stock option issuance, or acquisition. It helps to model:

• Fully diluted parentage ownership for outstanding shareholders

• Dilution

• Conversion of convertible securities (SAFEs, Convertible Notes)

• Ownership concentration – Major, lead investors

Example of Pro Forma Cap Table

XYZ, Inc. is valued at $10M Pre-Money and wants to raise $2M from investors in a Series A round. The company has a prior SAFE round which will convert in the new round for a 15% discount. Pro forma cap tables project:

• Price per share for SAFE investors and total number of SAFE shares

• Price per share paid by Series A Investors and total number of Series A shares

• Dilution
  

Retaining Ownership

At formation:

• Use vesting for service providers including among multiple co-founders

• Avoid using equity in lieu of cash too liberally – consider different equity compensation philosophies.

At funding:

• Not all dilution is bad – funding at a favorable valuation is generally a good kind of dilution

• How much is typical for investors to own post-closing “fully diluted”?

  • Varies widely, but ballpark 7-15% for Series Seed, 35-45% for Series A (including all investors to date, which often means Series Seed plus Series A collectively own ~40% post-A)

  • Founders (together with early hires or other early common stock holders) will generally still own a majority after Series A

Tip List

• Keep the cap table current and maintain confidentiality

• Include comments when helpful (e.g. for convertible instruments and vesting schedules for options)

• Don’t promise percentages to new hires – use fixed share or unit counts, and if you need to use percentages, state them as approximate and as of a specific date making clear it will be subject to ordinary dilution.

• Observe formalities, including formal board consent, for equity issuances

• Use vesting for equity issuances to service providers, including co-founders

• Consider an online management platform (e.g., Carta) when the cap table becomes more than a few holders

Disclaimer

No attorney-client relationship is created by use of or reliance on these materials or the accompanying discussion. The information contained herein is a high-level overview in general terms and does not constitute legal advice.

Stubbs Alderton & Markiles, LLP is a business law firm with robust corporate, public securities, mergers and acquisitions, entertainment, intellectual property, brand protection and business litigation practice groups focusing on the representation of, among others, venture backed emerging growth companies, middle market public companies, large technology companies, entertainment and digital media companies, investors, venture capital funds, investment bankers and underwriters. The firm’s clients represent the full spectrum of Southern California business with a concentration in the technology, entertainment, videogame, apparel and medical device sectors. Our mission is to provide technically excellent legal services in a consistent, highly-responsive and service-oriented manner with an entrepreneurial and practical business perspective. These principles are the hallmarks of our Firm.

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