Introducing the Cap Table and Hiring the CTO

As Finance Fridays continues, we are introducing the concept of the Cap Table. We recognize that we are still at the very early basics stage, but as we are taking a case study approach to this we feel like we have to set up all of the pieces before we get into the messy guts. Hopefully you are staying with us and finding this useful – feedback welcome!

Jane and Dick, our fearless cofounders of SayAhh, have set up an accounting system and created their first set of financial statements. This week they set out to create their cap table and hire a CTO.

The founders each have common shares that will vest over four years. The vesting schedule protects each of the co-founders in case one gets hit by a bus or decides to drop the project after a short period of time. Also, there is an important tax election called an 83(b) election that they made which allows them to recognize and pay taxes for very small income of the value of the shares. Later, if they sell, the low tax basis and capital gains tax rates result in a lower tax liability than if they didn’t file the 83(b) election.

Equity is split 55% and 45%, but where is that officially recorded? It is not in the three primary financial statements (the Balance Sheet, Profit & Loss, and Cash Flow Statement.) Rather, it gets recorded in a document called the Capitalization Table (or “Cap Table”), which shows the ownership stake each person or entity has in the business.

Below you can see Jane and Dick own 55% and 45%, respectively. As first time entrepreneurs they did not create an employee options pool; we’ll fix that in a little while.

Jane and Dick want to bring in their friend Praveena as CTO, but they don’t know how to structure the compensation. They come up with two options:

  1. Hire Praveena as an employee and offer her stock options.
  2. Bring Praveena in as a founder and offer 10-20% of the company as stock.

The benefit of hiring Praveena is they think they could keep more equity and control of the company. But, Praveena hails from the land of big paychecks and is not ready to leave that without considerable equity. With the funds Jane and Dick have, a big salary is not possible. Praveena wants to invest $20,000 and get 20% equity.

After several discussions (and more beer), Jane and Dick agreed with Praveena to bring her on as a cofounder where she invests $20,000 and also gets 15% equity. Praveena is just like the other two founders, where her equity will vest over 4 years. Time to update the cap table.

 

When you read the cap table, think of it as a series of events that add new columns to the right. Now there are two events: the initial issuance of founders common shares, and then issuing new founders common shares along with creating an options pool. In this manner, you can see both the current equity distribution of the company, as well as historically what the equity holdings looked like.

If the full pool were to be given out, the dilution is fairly significant to the founders. They would own from 55% and 45% down to 36% and 29%, but until options are exercised they are not diluted. Jane and Dick contemplated a small option pool because they had read about the risk of an option pool shuffle, but ultimately decided to make it 20% based on feedback from their friend Josh, a Boston-based venture capitalist.

Our (now three) co-founders begin building out their product. The co-founders have savings to live off of and cash will be conserved by not having any salaries. Next week we will fast forward to when they have a beta product and they build a model to pitch to investors.

  • http://rpmware.com Kyle West

    Great article as always, Brad. 

    I think it’s important to demonstrate how one determines the number of shares Praveena receives, how many are set aside for the options pool, and why the total shares went from 10M to 15M. To someone just learning this it may seem correct to simply adjust the % and “move” shares from Jane and Dick to the others.

    Kyle

  • http://twitter.com/jeffreyiacono Jeff Iacono

    Brad – what happens to that options pool if a liquidity event happens (ex. they are bought out) before any of the options are assigned? Is it dependent on how their founder agreements are structured or is it a best practice that they split the remaining equity (20% in this case) according to current ownership? With the option pool unallocated, there would be 12,308,500 outstanding shares, and holdings would be Jane @ 44.7%, Dick @ 36.6% and Prav @ 18.8%, so would that ownership distribution be maintained under these circumstances? Thanks!

    • http://www.feld.com bfeld

      You are correct.

      Usually the unissued options just vanish into thin air. As a result, the # of fully diluted shares outstanding is reduced by that amount. The relative ownership would be preserved.

      • http://www.crashutah.com John

        This was my question too.  If that’s the case, then shouldn’t you have diluted Prav’s 15% share since he’ll get the options back if they aren’t assigned?  I guess this would all be part of the negotiation with Prav, but would be an important part of that negotiation no?  I guess it’s more of a question of whether Prave was added before the options pool or after, right?

        • Brian

          This was troubling me also.  Would it not make sense to bring Prav in with 1.765M shares, making the total split Jane+Dick 85/Prav15? Then add a pool of 2.941M shares and proportionally dilute all three cofounders.  I guess you can negotiate any way you choose but seems to me that all the cofounders should share in forming the pool.

  • Todd Werelius

    So what happens if 

    Two founders start with a 50/50 split, say 80 shares total (just to make the math easy) 

    Then they bring on someone for 20% so total shares are now 100

    Now one of the original founders quits, if his shares just “Disappear” that leaves the first founder with 66% and the late comer with 33% of outstanding shares, which would not seem right.

    Seems like issue date would be important to group and recalculate if such an event happened, if the late comer quit it works fine to have that happen, but not a member of an earlier group. 

    That is all those with shares issued on date X would be a group, so if one of the that group was removed that entry would disappear (or have shares reduced if some where vested) and and the table recalculated top down. 

    Is that correct? 

    • http://www.feld.com bfeld

      Actually, the resulting split of 66.7/33.3 is the right answer. Each person’s ownership increases “pro-ratably” based on the shares that go away. Now, there are other ways to handle this, such as return the shares to the option pool for issuance to a person (or people) to replace the departing founder. Alternatively, the two remaining people could agree to allocate these shares to themselves in different proportions. So – while there is no hard and fast rule, I think the resulting 66.7/33.3 split makes sense in this case.

  • Pingback: Reblog – Finance Fridays (Introducing the Cap Table and CTO) | ithacaVC

  • zach shulman

    Hi
    Brad – hope your Labor Day weekend is good.

     

    Anyway,
    I just expanded your Finance Fridays on cap tables.  I also included a
    template.   Here you go:  http://ithacavc.wordpress.com/2011/09/04/reblog-finance-fridays-introducing-the-cap-table-and-cto/

     Thx.

    • http://www.feld.com bfeld

      Good adds Zach – thanks!

  • http://www.moncler-jackets-it.com/ Panciotto Moncler

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    • http://www.feld.com bfeld

      We are assuming that Prav go the 15% on a fully diluted basis (rather than pre-the option pool).

  • joshua forman

    The whole Finance Fridays and comments it generates have been really great. Very informative. Thanks for taking it on!

  • http://nicholaskreidberg.com Nicholas Kreidberg

    Great series of articles!  Just FYI the image links work when clicked but the images don’t show up in the post.

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  • http://jordanopen.myopenid.com/ Jordan

    New Share Calculations: 

    So because you’re creating the option pool (20%) and the 15% for Praveena. You need to dilute the founders (existing shareholders) by 35% (20%+15%). You would do this proportionally, of course. So Jane’s % would drop from 55% to 35.75% (55-(.55*35)) and Dick’s from 45% to 29.25% (45-(.45*35)). Therefore Dick and Jane’s 10 million shares represents 65% of the company (=35.75+29.25). Now 5,384,615 new shares must be issued to cover options pool and Praveena’s 15%. 15,384,615 = 10,000,000 / .65, and 15,384,615 total shares – 10,000,000 existing = 5,384,615 new shares, which is equal to 35% of (new) total shares (15,384,615).Of the 5,384,615 (which represents 35%), the option pool (20/35*5,384,615) comes to 3,076,922 shares. And Preveena’s 15% comes (15/35*5,384,615) or 2,307,692 shares.Did I get this right? (Slight differences due to rounding).

    • http://www.feld.com bfeld

      I think so. I read through this rather than created a spreadsheet to back check, but I think you’ve got it.

      • http://jordanopen.myopenid.com/ Jordan

        You Rock Brad. Financial Fridays WINNING!

        • http://www.feld.com bfeld

          Thanks. Look for another one this Friday.

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