Building clear frameworks for your startup is one of the most important first steps in any early-stage business. A cap table, or capitalization table, is the base of the framework. This living, breathing document outlines the equity structure of your startup, and will shift and change throughout the lifecycle of the business. The cap table can serve as an equity roadmap, clarifying roles, responsibilities, timelines, and provisions. This helps founders, employees, and investors understand expectations at every stage of the company.
Drafting your cap table should be a priority as soon as more than one person becomes involved in the business. Proper equity allocation and distribution are imperative, so it’s important to get this correct from the get-go.
While online tools are widely available, having an attorney review your cap table is critical. This ensures proper and thorough legal documentation, keeping founders protected as the startup grows.
At HJF Law, we’ve helped many startups draft their cap tables. Every business is unique and will have its own nuances, but here are the top considerations to contemplate as you begin drafting your cap table.
Ownership Structure
In the very beginning, a startup’s ownership structure may be very simple to determine. Founders should understand the initial structure serves as a baseline for how the company is controlled. Defining each stakeholder’s role, the types of equity they own, and their vesting schedules demonstrates the structure to potential investors.
Further, there must be an understanding that the control will shift as the company expands. Forecasting for the changes that will occur when additional parties join the company, and outlining these, in the cap table creates a clear path for how to proceed.
Option Pool
Some of this forecasting involves the option pool – a percentage of shares allocated for later utilization. Founders must consider how many shares to include, who will gain access to those shares, and when to make them available. Founders planning to hire executive-level employees may consider company equity as part of their compensation package, so making sure the right amount of shares are set aside for this purpose is critical to company growth.
Level of Control
Cap tables do more than outline equity structures, they also include provisions that dictate the level of founder control. When drafting a cap table, founders should consider their future visions for the company, and what level of control they are willing to negotiate. Many founders include provisions in their cap table to protect long-term company interests.
Rights of First Refusal
Incorporating rights of first refusal gives the company, and sometimes current stakeholders, the opportunity to purchase shares before a stockholder sells them to an outside party. This protects the company by keeping ownership within a trusted circle while preventing shares from being purchased by a competitor or an unknown buyer.
Pro Rata and Pay-to-Play Provisions
Pro rata rights allow existing investors to maintain their ownership percentage. During funding rounds, equity owners maintain their percentage rather than it being diluted by additional investors. This ensures a guaranteed path to maintaining company control.
Pay-to-play provisions raise the stakes further, requiring investors to continue investing in subsequent rounds at their existing proportion. If they choose not to continue, they risk their preferred shares being converted to common, or potentially losing a seat on the board. This can be especially helpful during down-rounds. However, it could dissuade potential investors from joining in the first place.
Funding Rounds
Well-organized cap tables do more than provide an equity roadmap for founders. Clean and clear interest outlines prove founders’ stake in their business. This demonstrates to investors that founders will maintain development of the startup once funding is received, giving investors additional confidence in becoming a part of the business.
Founders must consider how their equity structure will appear to potential investors. It’s also key that cap tables are continually updated, further demonstrating professionalism while conveying future visioning for the company.
Vesting Schedules
Improperly outlined vesting schedules could lead to diluted or stalled cap tables, creating the need for extensive redistribution efforts at complex growth stages. Considering various dilution scenarios can help prevent confusion in unforeseen circumstances.
Vesting schedules exist to protect startups and their cap tables, safeguarding ownership, equity, and confidence as the business grows. Indicating triggers for accelerated vesting within cap tables completes the company’s lifecycle predictions. Outlining multiple scenarios does more than provide structure when stakeholders exit earlier than predicted. It further amplifies the startup’s strength and confidence to investors in advance of funding rounds.
Dilution/Liquidation Provisions
When discussing venture capital, liquidation refers to more than just bankruptcy. As a startup grows, it gains more investors, and founders’ shares often become diluted. Small share percentages can be worth more than original larger percentages. Common stock may translate to preferred stock, or vice versa, depending on a number of scenarios. When the company goes public or is acquired, outlined liquidation preferences clarifies who gets paid.
While it can be challenging to imagine the sale of a company years ahead of time, considering dilution and liquidation provisions when crafting a cap table can provide positive reassurance to stakeholders. When outlined properly, each stakeholder can understand how their shares will be affected during their exit or during the sale of the company.
Ensure Your Cap Table is Clear and Complete with HJF Law
Cap tables can be complex and confusing for new founders. At HJF Law, our team of startup experts can help founders understand everything there is to consider as cap tables are being drafted. Additionally, it’s a good idea to have an attorney review your cap tables at each funding round and each milestone stage to ensure your startup remains protected.
It’s never too early to hire a lawyer!
Even if your startup is in the ideation phase, securing counsel now can ensure foundational documents are properly outlined, assuring stakeholder confidence throughout the lifecycle of your company.
Reach out to our team at (917) 726-8184 or contact us here for your free consultation.