Fundraising and the Importance of Modelling Your Cap Table
A capitalization table, also known as a cap table, is a spreadsheet or table that shows the equity capitalization for a company. A capitalization table is most commonly utilized for startups and early-stage businesses but all types of companies may use it as well. In general, the capitalization table is an intricate breakdown of a company’s shareholders’ equity. – Source: Investopedia (see full entry)
Fundraising is an important and, depending on the situation, very involved topic. Goodness knows there is a ton written about fundraising for start-up companies and much of it is worth reading – especially if you have not been through the process before. However, there is nothing quite like living through a financing and feeling the feelings that go with raising private capital – it simply leaves impressions on you that you wish you had understood a little better when you were just thinking about raising money. This blog is about understanding how a financing may affect your ownership – and the tool that helps you determine that before the financing happens. We are talking about the cap table and more specifically the importance of having a cap table model.
Start-up CEOs and their teams know that the relative complexity of fundraising increases as you move from one round to the next. For example, if you start by bootstrapping your business there can be a ton of personal financial stress associated but you are only accountable to yourself, your bank account, your significant other, your VISA bills, etc. When you start taking money from “investors”, well, things start to feel a bit different, perhaps more serious or accountable.
Many start-up founders go to friends and family for early money (or perhaps they approach a few angels or perhaps even a funding organization that is willing to come in and take an early bet on the company). In return for the money investors are typically offered a SAFE (Simple Agreement for Future Equity), a Convertible Debenture (CD) or Common Shares. Specific investment instruments have their pros and cons for the company and for company shareholders. Whether you have taken money from investors in the past or will sometime in the future, make it your business to understand the different investment instruments available for use as well as the potential
implications of them for your company and for your investors / shareholders.
For example, SAFEs and CDs have the advantage of allowing companies to avoid the effort of putting a value on the company until a future funding event. This can have appeal for companies that are relatively early in their start-up journey. Also, SAFE and CD financings can typically close more quickly than an equity round because they are relatively simple to execute by comparison. There is a “but”, however. The money from such investments come with terms that determine their conversion into company equity at some point in the future. SAFEs and CDs often include: 1) a “cap” on the valuation at which the investment (plus interest in the case of a CD) will convert into equity, 2) a threshold future equity financing amount that triggers the equity conversion, and 3) a discounted share price (for the SAFE holders or noteholders) with respect to the shares received at conversion. It is often not until the company is doing a financing round (like a Seed round or Series A) that the impact of the SAFEs or CDs are fully understood, seen or considered by start-up founders.
A model of your cap table let’s you do “what if” modelling and generally understand the scale of dilution that would be imposed by new equity financings (common or preferred share) well before the term sheet shows up. Your imagination, together with the model can generate countless scenarios. Afterall, nobody wants to be surprised where it comes to the dilution impact a SAFE or CD might have on yourself, other founders (and any other shareholders you have).
The power of having a model that shows the impact of a financing on shareholder dilution will serve you well. Such a cap table model not only considers the effect of converting CDs or SAFEs, but it will also show the impact of adding an ESOP or increasing the ESOP pool, the impact of new preferred series shares and how it all relates to pre-money and post-money valuations. And for those of you who may be reading this and have or plan to take on US investors, tools like this can help you understand the impact of financing to your CCPC (Canadian Controlled Private Corporation) status. Maintaining CCPC status offers benefits such as a lower corporate tax rate and an enhanced tax credit under the SR&ED program.
When start-up CEOs think of fundraising, they likely think of many things, I am sure. Is my pitch ready? Is it synced to my financial projections? How much money does the company need and what milestones will the money allow us to achieve? There are many important questions to be considered. I submit that an early understanding of how the prospective financing will affect your cap table will help avoid unwelcome surprises.
About Bill
I have been working with start-up leaders and innovators for over 20 years in Halifax, Nova Scotia. I have worked in companies as a mid-level manager, as senior and executive management, as a founder and, on and off for the last 14 years, as an embedded executive and advisor.
If you would like to automatically receive this newsletter in your inbox, or if you have questions about how I can help you and your start-up company email me at bill.power(at)powerforward.ca.
