It is common for many companies, particularly during the start-up phase, to choose to use equity as currency. They sell small (and large) allotments of shares to friends, family and investors as well as sometimes offer shares to essential service providers in return for the help they need in advancing the business.
However, problems can arise when such offers are made without consulting a lawyer. These problems are often a result of imprecise language along the lines of: “We are prepared to give you 5% of the company in return for developing the App we need . . . ” because the outcome of what 5% represents isn’t properly understood or expressed.
Before we look at this issue it is important to note that whenever a company offers shares or stock options to any person, a lawyer should be consulted to ensure the offering complies with applicable securities legislation, which generally restricts such distributions unless it is completed pursuant to a prospectus or an exemption. To simplify the discussion below, we will assume all distributions discussed are made pursuant to such exemptions.
As a business owner planning to raise capital or use equity to compensate key service providers, such as your accountant or developer, it’s important to know your way around a share capital table — or ‘cap table’ as it is more commonly called. A cap table is a spreadsheet that tracks shareholdings in terms of number of shares held and the resulting ownership percentage. It is used to record and plan a company’s existing and anticipated share structure and ownership as it grows. It helps to analyze the possible consequences of your plans so that you can avoid costly mistakes.
The table below represents a simple, sample cap table for a company with four initial shareholders (founders), each having a 25% ownership position. For simplicity, assume that this company has only one class of common shares. From this starting point, the cap table can be expanded by adding columns to include share issuances and different classes of shares and rows to include new shareholders.
Every time a company issues new shares, its pre-existing shareholders are diluted by the new shares and end up holding a smaller percentage of what is hopefully a larger pie. For example, if the sample company in the table above issues 300,000 class A preferred shares to an investor in return for an investment of $200,000, each founder is ‘diluted.’ Now, instead of each holding 250,000 out of 1,000,000 shares, each one now owns 250,000 shares out of 1,300,000 shares. This reduces each shareholder’s ownership from 25% to 19.2%.
Using a cap table helps founders see the company’s shares as a constantly increasing pool rather than a static one, which is a common mistake. Founders who think in static terms may see 300,000 shares as representing a 30% interest in the company, because 30% of 1,000,000 equals 300,000. However, once the new shares are issued and the pool of shares increases, the investor actually ends up owning 23.1% of the company.
In investment terms, this is known as framing the offer in ‘pre-money’ terms because the share position is based on the issued share capital before the new shares are purchased. By contrast, most sophisticated investors think in terms of a constantly increasing pool of shares and draft offers in ‘post-money’ terms. A post-money position means the ownership interest is calculated including both the issued share capital and the additional shares to be issued to the investor.
The difference in these two perspectives can become a problem when someone is offered a percentage of the company (i.e. “We are prepared to give you 30% of the company for $200,000”) rather than a fixed number of shares. In the example above, the investor was offered 300,000 shares for its investment; by preparing a cap table, the investor would see that this would result in a 23.1% ownership of the company. However, if the founders offer the investor 30% of the company without specifying whether it is pre-money or post-money — the founders may believe they are offering 300,000 common shares, and the investor may be expecting 429,000 shares or 30% ownership post-money.
In a best-case scenario, this error simply causes confusion. In a worst-case scenario, it can result in a breakdown in the relationship, with one or the other accepting an unsatisfactory deal, or loss of the investment. Retaining a lawyer to clearly define a cap table is the most effective way to map out your share strategy.