Note: This article is the third in an ongoing series on valuation and capitalization. To learn more about the financial mechanics of early stage investing, download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.
In Part I of this article we gave an overview of capitalization tables and the key terms used in cap table analysis that every investor must understand: Valuations, Security Types and Share Counts. In Part II we'll take a closer look at how cap tables evolve over time, which deal terms can have the biggest affect, and the purpose of a waterfall analysis for early stage investors.
How do these cap tables evolve over time? What events result in a change to an early stage company’s cap table?
When a company is first incorporated, the cap table is pretty simple. Let’s say you have two company founders. At that time, the cap table will have some common shares issued to the founders, and that’s it. Simple!
Over time the cap table will necessarily become more complex. I like to think of changes to the cap table occurring based on two different groups: 1) New Employees, Directors and Advisors and 2) New Investors (and if they are given securities such as warrants, Creditors).
Employees, Directors and Advisors
As the company adds employees, directors and advisors, it will typically create and grant options, restricted stock awards or warrants from an “option pool” as a way to attract, incentivize and retain those people. Option pools vary in size, but are typically designed to represent somewhere between 5% and 25% of the total outstanding shares of the company.
Here are some examples of the employee, director and advisor events that will result in a change to or notation on the cap table:
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Establishing an option pool (more authorized shares if insufficient shares authorized, new line item on the cap table)
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Increasing the size of the option pool (more authorized shares, increase in the pool line item)
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Issuing an option grant, restricted share award or warrant to an individual, e.g. employee, director, advisor (new line item for the options, reduction in size of remaining pool)
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Exercising of options or warrants by an individual (reduction of their option listing, increase in common stockholder list and common shares outstanding)
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Terminating unvested options, unvested restricted share awards or expired warrants when an individual’s service to the company ends before options are vested (removal of an option line item, and typically a return of those shares to the pool)
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Any transfer of shares between an individual and another entity e.g. an investor or the company (a boost in shares issued and a new line item for that investor)
Investors and Creditors
Most early stage companies raise capital from a variety of sources over time including friends, family, angels and VCs. When capital is raised, it can take the form of either equity (partial ownership of the company) or convertible debt or straight debt with warrants (lender). In either case, this information should be recorded on the cap table. Here is a list of the events that will result in a change to the cap table due to raising either equity or debt:
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Selling new shares of an existing security, e.g. common shares (new line item for that shareholder, reduction in pool of authorized but unissued shares)
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Selling new shares of a new security, e.g. a new series of preferred shares (creation of a new class, often reflected in a new column on the cap table for clarity, plus new line items for the new investors)
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Issuing convertible debt through some form of note. Even though issuing debt typically does not result in an immediate issuance of shares, it’s important to record this information because it will lead to the issuance of shares or may have payment priority so it can affect an investor’s ultimate payout upon a company exit (new line item to reflect this debt and signal its potential impact for full dilution calculations)
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Issuing warrants as part of either a debt or equity round of financing (new line item, possible reduction of the option pool if the warrants use the pool)
The above lists are not a full set of all the events that can impact a cap table, but they cover the most common events in early stage companies and give you a sense of the landscape. We can’t emphasize enough the importance of a company recording any events that might impact a cap table. If a company and its investors don’t have a good handle on company ownership, they may run into serious legal issues down the road, including the potential for fraud claims.
So what are Convertible Notes? How do they affect the cap table?
Convertible notes are debt, but a special kind of debt that is not meant to be paid back in cash. Instead, it is meant to convert into shares of the company at some future date. So it blends concepts of both debt and equity. Regardless of whether it has converted or not, it is important for the cap table. Remember that in almost all liquidation situations, debt holders are paid first before any proceeds can be paid out to equity holders. Therefore, you need to know how much debt is outstanding, whether any of it is convertible, and what the terms of conversion are, before you can fully understand how big a slice of the pie you will ultimately end up with. All debt should be recorded in a section of the cap table.
It is helpful to include the following information in the cap table document so you will understand how much equity might be issued to noteholders at some point in the future:
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Date the debt was incurred
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Amount of indebtedness
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Interest rate
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Interest rate calculation mechanism (annual, semi-annual, cumulative, non-cumulative)
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Maturity date (due date)
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Terms and conditions driving conversion.
Then usually immediately after those terms there will be some discussion of any financial terms relating to conversion, such as a negotiated cap on the conversion price or discount against the conversion price if the deal features a cap or discount.
It is not uncommon for an early stage company to raise more than $1M using convertible notes. That amount can represent a significant position on the cap table once it has been converted, so make sure you keep track of it.
Ok, so those are the basics, but what are some additional early stage deal terms that can affect the cap table?
The two biggies are the liquidation preference and the anti-dilution provisions.
A common feature found in preferred stock is the liquidation preference. This feature of preferred stock gives the preferred shareholders the right in a liquidation to be paid a specified amount before common stockholders are paid anything. The liquidation preference is typically expressed as a multiple (e.g. 1X, 2X, etc.) of the amount of the investor’s original investment. For example a 1X preference gives the investor the right to get one times their money back before any distributions to other shareholders with lower priority.
To shed some light on this term, let’s give a simple example:
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Suppose you own the less-common and more investor-friendly form of preferred stock, participating preferred, with a 1X liquidation preference.
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You invested $1M at a $4M pre-money, so you own 20% of the company.
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If the company is acquired for $10M you would expect to be entitled to 20% of that $10M, or $2M, but it is not that simple because of the terms of the deal; instead, your payout is as follows...
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First, you get paid your liquidation preference. In this case, that is equal to $1M (i.e. one times the amount of your original investment.)
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Next, you get paid 20% of the remaining value of the company. In this case that will be 20% of $9M or a total of $1.8M
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Your total payout is $2.8M. That equals 28% of the acquisition price for the company. So that 1X liquidation preference had a pretty large effect on your ultimate returns in this example.
The other biggie is the anti-dilution provision. This is a provision which acts like a “magic” adjustable price for shares. Shares which come with anti-dilution protection have the right to be repriced downward in the event that later shares in the company are offered in the future at a lower price. Exactly how they are repriced can be complicated (most deals specify that a broad-based weighted-average calculation be used and that additional shares be granted as the mechanism for “repricing”), but for our purposes, the details of precise calculation don’t matter. What matters is that if the transaction for which you are analyzing the cap table is not an upwardly priced round and might trigger anti-dilution provisions, a whole bunch of shares may flood into the cap table analysis as compensation to those folks on the lines where the relevant shares are located.
Also, an important reminder: one frequently-overlooked term is the dividend. Sometimes there is a dividend quietly ticking away and accruing (either on a cumulative or non-cumulative basis) to the benefit of one or more classes of preferred stock. Many exits end up taking far longer than anyone originally anticipated. In these cases, having a dividend accumulating in the background can make an enormous difference in the ultimate ownership (and returns) of the different classes of stock. For example, using the rule of 72, an 8% dividend alone will give you a 2X all by itself if left to run for 9 years. So make sure the cap table indicates or you research which securities are paying dividends and what the start date is on payment of those dividends.
This is getting complicated. I hear the term “waterfall analysis” used a lot by some experienced angel investors in my community. Is that what we are talking about here? What is the purpose of a waterfall analysis for an early stage investor?
In Part I of this article, I showed a very simple cap table. It’s extremely rare for an early stage company to get all the way to an exit with such a simple cap table. Over time, complexity is added to the cap table as you raise capital, incur debt and hire employees. Understanding the effects of liquidation preferences, dividends, interest, warrants, etc. can be quite complex. That’s where a waterfall analysis comes into play.
A waterfall analysis is the technical term used to describe the process of calculating exact amounts each shareholder and debt holder will be paid upon any liquidation event of the company (e.g. an acquisition, an IPO, etc.). Basically it is just a sequential series of calculations where you apply the various deal terms to the cap table in the order required to flow the whole thing through to the end.
If you are interested in digging deeper to understand how the waterfall analysis works, take a look at our example cap table. We have a separate tab in this spreadsheet called “Waterfall Analysis”. This shows you an approach for modeling a variety of exit scenarios.
There are so many variables that drive the eventual outcome of your investment in an early stage company. If you are lucky and invest in the next Facebook, you won’t worry about dividends, warrants and liquidation preferences. They don’t matter all that much in such a huge exit. But for the more typical exit, where a company is acquired for less than $100M, these terms do matter. So make sure you grasp the basic concepts and you will become a better investor.
Next up in this series: Approximations, Assumptions and Aspirations: Methods For Valuing Startups.
Want to learn more about the financial mechanics of early stage investing? Download this free eBook today Angel Investing by the Numbers: Valuation, Capitalization, Portfolio Construction and Startup Economics or purchase our books at Amazon.com.
