Lesson #152: The Importance of a "Clean" Capitalization Table for Investors

A company's capitalization table clearly lays out all the equity and debt ownership and liquidation rankings of the various investors or lendors invested in a business.  For most startups, that is typically a list of the various stockholders and their percentages owned, since most startups do not typically attract traditional debt lenders.  But, equity takes many forms, from common stock to preferred stock to convertible debt, all with various implications to current and future investors.

Here is an example cap table:

5% Convertible Notes:
     John Smith  $100K (converts to 100K shares at $1.00/share=3.6%)
     Susie Smith $100K (converts to 100K shares at $1.00/share=3.6%)
Preferred Equity:
     Dave Jones, Investor  $50K (200K shares at $0.25/share=7.3%)
     Mike Williams, Investor  $25K (100K shares at $0.25/share=3.6%)
Common Stock:
     Jay Johnson, CEO  (1.0MM founder shares at $0.00/share=36.4%)
     Kurt Matson, CTO  (500K founder shares at $0.00/share=18.2%)
     Lisa Francis, CFO  (500K founder shares at $0.00/share=18.2%)
     Employee Stock Options Reserve (250K=9.1%)
Total Shares Outstanding Today (2.30MM shares=83.6%)
Total Fully Diluted Shares Outstanding   (2.75MM shares=100%)

Notice that the cap table is in liquidity rank order, with convertible note holders the most senior security paid back before anybody, followed by the preferred equity holders, and finally followed by the lowest ranking common shareholders of the business.  Also notice that the cap table shows the fully diluted ownership of the company for currently outstanding shares, as well as contractual obligations to potentially issue future shares, like the potential convertible notes conversion and the future employee stock options reserve.  And, the cap table should also clearly detail the price paid per share for the securities, so new investors have a sense to the valuation history of the business.

Now, here are example of things that future investors will be looking out for in your cap table, before making a new investment into your business: 

• Where will the new investor sit in the liquidity ranking--most new investors wants to sit on top of the pile, paid back before others. 
• How many investors are involved--they prefer tightly held businesses without too many investors for easier communications and vote collecting. 
• What impact will their investment/valuation have on the other investors--if they are investing in a down-round (lower valuation) than previous investors, the other investors will be disgruntled out of the gate and new investors will want to avoid any potentially litigious situations. 
• Are there other professional investors involved--depending on stage, some investors want to be the first professional money involved with a business, and others prefer having other institutions involved. 
• Who are the other investors--they want synergistic and "friendly" investors around the board of directors table. 
• Is management properly incentivized--do the employees have a big enough stake to stick with the business. 
• Are the founders' equity stakes tied to a vesting schedule which they earn over time--investors don't want founders walking away with a big equity stake if they quit.

So, based on the above, any actions you take today, as it relates to your investor base and capitalization structure, could have future implications on your attractiveness to future investors.  So, think far enough ahead, so you don't run into any potential problems down the road.

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