What Is a Cap Table and Why Is It Important?
When starting a business, entrepreneurs are told that it is crucial to get everything in order before making any deals with external investors. Many times the initial investment is low which makes it tempting to ignore this advice and simply grow the company without formalizing the legal structure.
But for most start-ups, building a cap table can make or break their success or failure.
What Is a Cap Table?
A cap table is a spreadsheet that lists all of the owners of company equity. These are broken down by their percentage ownership, which can be expressed as preferred stock, common stock, or options. It also describes how many shares are held by investors, employees, and founders.
What Is It Used For?
The purpose of creating a cap table is to be able to track the financial interests of the company’s stakeholders. This will help you to easily organize and manage ownership of a business, as well as calculate equity splits for future financing. It is also used by tax authorities for reporting income made from distributing shares upon a company’s liquidation or merger.
Why Can a Cap Table Be Complicated?
While this may look like a simple spreadsheet, the details of company shares are actually more complicated. For example, companies need to account for early investment rounds by creating different classes of stock with varying numbers of votes. Or they must pay attention to how many options are allowed per share when creating an employee pool.
When building a cap table, there are some great resources available to help entrepreneurs through the process. These include instructions, tutorials, and best practices documents. Once you have worked out the key details for your cap table, it can be beneficial to consult with an attorney or accountant before making it public.
Why Is a Cap Table Important?
Having a cap table does not just protect your business, it also protects yourself and the other stakeholders. This is especially important when planning an exit strategy since it allows you to know precisely how much money each person will make from the transaction.
Additionally, having a cap table in place makes future transactions possible. For example, if you want to sue someone for breach of contract, you will need to have a valid cap table. This helps both parties involved to establish who owns what percentage of the business. And whether or not they are in breach of their contracts with your company.
Making a corporation shareholder-friendly is also an important factor for investors. If a new investor comes on board, they will likely want to see the cap table. This way, they can make sure they are receiving the proper amount of shares. And this makes it easier for them to assess whether or not your business is a worthwhile investment.
How Can I Build a Cap Table?
Having a cap table can be extremely useful, but building one takes time and patience. To begin with, you need to determine what information you need to track within your spreadsheet. This will make it easier to establish the percentages assigned to each owner.
The crucial element in your cap table is determining whether or not you need a special class of stock. If so, you must consult with an attorney and determine the legal implications that come with this choice.
Once you have the legalities down you can go ahead and build out your spreadsheet. Most professional cap tables are broken down by investors, employees, and founders. Although the breakdown for these groups varies widely depending on your company’s structure.
Common Mistakes When Creating a Cap Table
1. Having Too Many Classes of Stock
One of the most common mistakes with creating a cap table is having too many classes of stock. This makes it impossible for you to properly manage ownership. It also makes it more difficult for others to determine the value of your company.
2. Not Having a Cap Table At All
Having no cap table is the worst thing you can do. It makes things confusing for investors, employees, and other stakeholders. Oftentimes people think their legal agreement is enough to cover their business dealings. However, when you make an exit later on or experience a liquidity event, this will cause problems for everyone involved.
3. Not Having a Shareholder Agreement
Having a proper shareholder agreement is crucial – considering the potential legal issues that can come up if you do not have one in place.
4. Not Having a Valuation Agreement
Another mistake to avoid is not having a valuation agreement in place. This is a document that establishes the value of your business for the purposes of ownership percentages.
As you can see, a cap table is an important document to have for anyone who is involved in business. The consequences of not having one can be huge, so it’s always best to have one in place.