Capitalization Table Management for Startups
Startup companies need different kinds of help, guidance, assistance and talent to turn their ideas into profitable businesses, but they typically don't have excess cash to spend. So entrepreneurs use equity in the company as a strategic substitute for cash in special cases.
While offering startup equity can be a competitive advantage, it also has a substantial record keeping requirement. Every transaction related to equity must be recorded in a journal called the capitalization table, or "cap table." The complexity of the way that stock can be given makes the cap table difficult to maintain and prone to error. However, the information in the cap table also helps owners with government compliance and is a critical tool that owners can use when negotiating terms from outside investors.
While some companies might start recording initial founder equity splits on a spreadsheet, they quickly discover that the spreadsheet is an inadequate tool for maintaining a cap table, just as the spreadsheet would be inadequate to run the company's payroll. Fortunately, there is custom software available that's designed specifically for maintaining cap tables and provides analytical and modeling functionality that spreadsheets don't include. Equity Token is a tool that companies use to ease the administrative burden of maintaining cap tables.
Equity as a Strategic Tool
Founders often rely on knowledge and expertise from external advisors when launching a new company. Even though a typical advisor might only spend a few hours a month providing advice to company owners, advisors usually provide high value in intangible ways. For example, an advisor might provide clout by lending her name and reputation to be listed as a formal advisor. Or, an advisor might make introductions to key influencers in the industry and open doors for the company that lead to new relationships and sales.
To compensate these individuals for their contributions, company owners might divide a certain percentage of the company's equity, for example, one percent, among its formal advisors. The stock would typically vest over a two-year period. This keeps advisors engaged with the company and provides them with the opportunity to profit from their advice, guidance and other intangible contributions.
Recruiting top talent is a challenge for every company, but it's even more difficult for a startup that can't afford to pay the same salaries as large, established companies. However, a startup can offer a lower salary plus something that established companies can't offer: the potential to become rich in the future from owning company stock. When Facebook went public in 2012, about 1,000 employees became millionaires overnight. After Microsoft's IPO, about one in five employees became millionaires.
Entrepreneurs might set aside anywhere from five percent to 10 percent of the company's equity to use when recruiting, retaining and rewarding employees. There are many different ways owners can use stock with employees, such as stock grants, where the company gives shares to employees; and stock options, where the company provides the option to buy stock in the future at today's value. Each has different tax consequences for both the employee and the company. Most stock awards vest in increments over a certain period, such as 25 percent per year for four years and If the employee leaves the company early, he forfeits his unvested awards.
Complexities and Benefits of Maintaining a Cap Table
As you might imagine, maintaining the company's cap table becomes very complex when you award stock to individuals other than the founders. Every owner, advisor and employee might own or be entitled to a different number of shares of stock in the company. Each award must be recorded in the cap table, along with the legal documents that describe the agreement between the company and the individual. As stock vests, those transactions must also be recorded, and when employees leave the company, their accounts and the pool available for employee stock must be adjusted.
It's imperative that the cap table is maintained on an ongoing basis and updated every time a transaction takes place to ensure that it is always current and accurate. It's nearly impossible to create a cap table in the future by trying to recall the agreements and promises that were made in the past, especially when those agreements might not have been properly documented. In the end, it's typically the owner who loses equity by agreeing to an employee's recollection of a promise made to avoid a conflict or lawsuit. If a company is valued at $10 million, every error of just one percent in the cap table costs the owner $100,000.
With the right tools, the benefits of having a current and accurate cap table are well worth the time spent to maintain it. An up-to-date cap table gives you the ability to regularly update advisors and employees on the amount of equity they own. If you can determine a rough estimate of the company's value, you can translate that ownership percentage (both vested and unvested) into real dollars. Government reports for IRS and other compliance regulations are also easy since the IRS accepts the cap table for its required equity documentation. However, company owners will realize the biggest benefit of the cap table when they look for outside investment to grow the company.
Cap Table as a Strategic Tool
If you've ever watched "Shark Tank," you know that some investors are willing to trade cash for equity in a company they believe will substantially increase in value. The funding process is a negotiation to determine how much cash they trade for how much equity. Fortunately, most founders don't have to make a split-second decision as is required on the television show. They can take time to model and project different scenarios to determine what kind of deal they are willing to make and how it impacts their personal finances. That modeling and projecting are easy when you have a current and accurate cap table.
If the founders will decide to sell the company, the cap table plays an equally important strategic role in determining the price the owners are willing to accept and the financial implications for the founders, advisors, and employees.
Whether accepting outside investment or selling the company outright, the first document potential investors or acquirers will request is the cap table. During the due diligence phase, auditors will review the cap table in detail to compare the information in the supporting legal documents and agreements to what's been recorded in the cap table. Any errors or omissions can slow down or even jeopardize a deal that's been agreed upon in principle.
Software for Maintaining Cap Tables
Inexperienced entrepreneurs might make a first attempt at tracking a cap table using a spreadsheet program, but they will quickly realize that the cap table is too complex for a spreadsheet and too important to risk getting it wrong.
It would be like trying to run company payroll using spreadsheets. In theory, a company could do it. In fact, there are templates online that you can download for that purpose. However, once you have more than one or two employees, it becomes clear that payroll is too complex for spreadsheets. It requires custom software that's designed specifically for running payroll to help ensure that no mistakes are made.
The same is true for cap tables. It would be a poor management decision to maintain a cap table using a spreadsheet, and owners wouldn't reap any of the strategic benefits of having cap table data, such as reporting and analytical capability. Software created for cap tables will automatically make adjustments as stock vests and will prevent you from making common errors when entering data. Not using software designed for cap tables might raise a red flag with potential investors that the owners aren't equipped to make the right business decisions to scale the company after they acquire funding.
Finta is designed specifically to issue stock, record and manage equity. It has built-in support for vesting shares and provides the analytical tools that will help you make the right decisions when you've invited outsiders to invest in the company.