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Cap Tables: The Provenance of Diligence

So, you’ve aced the investor screening call – the gateway to the world of diligence. Amidst the various facets of scrutiny, one cornerstone of all diligence stands tall: The Capitalization Table, or as we in the startup realm fondly call it, the Cap Table. But before we get into why it’s so important and how it’s used, let’s align on what it is.

What is a Cap Table?

A Cap Table breaks down the equity holders in the startup (private company). It will also showcase the number of shares each party owns, and the corresponding percentage of ownership. There are three different levels of detail that a Cap Table may come in:

  1. A basic Cap Table will break down who the common and preferred equity holders are.
  2. A detailed Cap Table will build upon the basic version and layer in the founder shares, employee stock option plan shares, and investors by round in which they invested.
  3. In addition to those aspects, a full Cap Table will include prior iterations of financing, the number of shares employees and warrants have vested and exercised, and details of important terms and side letters footnoted.

That seems like quite a bit to constantly track, doesn’t it? The good news is that Cap Tables don’t change that often. The bad news is that a mistake on the Cap Table is a giant red flag for investors because this document directly ties to how much capital everyone’s equity is worth.

How are Cap Tables used?

Investors and lawyers can use cap tables to review funding history, determine the number of shares that will need to be created as a part of a round, or even scenario model an anticipated outcome (a waterfall analysis). There are multiple tactical uses of a cap table.

If an investor is looking at a Cap Table, they are considering investing, and that investment will change the numerical values on the Cap Table (almost every time). Good founders will plan out their Cap Table keeping dilution simulations in mind, but great founders will treat this like an art piece they are creating, keeping in mind that each brush stroke leads to an image that ultimately will be perceived with opinion and scrutiny.

Why are Cap Tables important?

Beyond those tactical reasons, the paintbrush strokes start to tell the story of the Cap Table over time – a story of greed and power or optimism and fear. Do you remember the scene in ‘The Social Network’ when the CFO’s shares get diluted down to 0.03% before being escorted out of their new headquarters? Now that is a Cap Table story we hope to not repeat.

That is a good example, however, of how investors will be using this document to determine which type of story this startup is, by analyzing how much equity the lead investor took, how much equity the founders have given away, who has followed on in multiple rounds, how many investors it took to raise a round, or whether there was bridge financing or not. All of these are signals that feed into the tale of how this startup has made it this far and how it will continue its journey to unicorn status.

The art world has Sotheby’s, Art Institutions, and historians to meticulously track the history of a piece of art. That history is called the Provenance. It is almost as important as the actual piece of art. It legitimizes the piece while also walking viewers and owners through that piece’s journey throughout history. The Cap Table is the provenance of the startup. The names and values on that Cap Table indicate how the startup has changed hands and been nurtured over time. It can tell if the startup is a fraud or a potential hidden gem. It showcases the type of founders and investors they will be aligning themselves with for years to come.

Unlike the art world, startups won’t be hiring historians to document their future biopics from the onset. Instead, a startup has a few other resources at its disposal that we highly recommend. First, get a lawyer to come through the investment documents and create the first version of the Cap Table. This step isn’t necessary any longer, but it’s always a good idea to have your lawyer on board. Once that first version is validated, move it over to software that your investors can view on their own time; Carta and Pulley are two of the market leaders. Most VC funds will have portfolio benefits to get you a discount if you haven’t migrated over to an equity management solution yet. These solutions can mitigate numerous headaches you will have if your Cap Table is incorrect, kept on a messy spreadsheet, or if you get asked to create a fully diluted or pro-forma Cap Table in the future (more on that to come in later posts!).

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