Don’t gamble away the success of your company by failing to keep its stock ownership in good shape.
Launching a startup certainly has its risks and challenges, but it should not be a roll of the dice at the craps table (or something worse). As an Entrepreneur, you will need to understand your company’s equity ownership and have access to the related Capitalization Table (or “Cap Table”). If you do not, then you would be smart to educate yourself now to avoid big problems later. In short, a company’s equity capitalization refers to its outstanding equity and all rights to acquire equity, including all shares of Capital Stock, Stock Options (and other equity incentives), Warrants to purchase stock, and Convertible Promissory Notes. Equity capitalization information deals with your company’s ownership, and accurate information is essential to Stockholder voting, equity compensation, equity financings, M&A transactions, dividend distributions and other important corporate situations. The purpose of your company’s cap table is to help you capture, track, update and model this equity ownership information.
Follow the seven best practices outlined below, so that you don’t wind up playing Russian roulette with your company and its equity ownership:
1. Focus on Today; Don’t Promise Tomorrow
You know that you need to accomplish concrete, near-term objectives and milestones if you want to have a shot at realizing your longer-term goals and dreams. At the same time, your vision for the company is an important motivator for your team, and you may need to discuss the future in order to focus people on the present. You might even be tempted to provide reassurances that you will “take care of your team” in the future, without acknowledging that this sentiment is based on important assumptions about the future. We get it. Just remember that you cannot predict the future very well, but you can be sure that your company’s needs and objectives, and its capitalization, will change and evolve. Think about how sharing pieces of the stock ownership pie now might motivate your colleagues to the benefit of your company and all equity owners in the future. Your team will respect and appreciate your focus on the present.
2. Measure Twice, Issue Once
Get the stock allocations right, starting with the initial founder shares and later with stock option grants. All founders are not created equal, so don’t fall into the trap of four founders each getting 25% of the initial founder shares. Do the hard work and figure out the proper stock allocations at startup. Equity incentives also can be extremely valuable in fostering long-term dedication and performance by key executives and employees, which is more likely to be realized if they are subject to vesting. Make sure to impose vesting conditions on all equity incentives, starting with the founders. Equity ownership incentives also can help your company conserve precious cash that would otherwise be spent on compensation. Be thoughtful in deciding who gets what. You do not have an endless supply of shares and employees eventually will find out how the equity has been allocated. The outcome of this process will vary from company to company, and it is fair to say that mastering equity compensation is more art than science. Ask yourself, what is the relationship between equity ownership and your company’s goals? Does the company intend to secure venture capital financing? What is the Company’s philosophy for equity compensation? Can the Company afford to pay competitive salaries? What other key hires does the Company require?
3. Talk is Not Cheap when it comes to Stock Ownership
Document all equity grants properly with good agreements and related corporate approvals and securities law filings. Failure to do so can lead to lawsuits with your company’s stockholders, as well as land your company in legal hot water with the securities law regulators – don’t forget that your company is issuing securities! Remember also that a commitment to issue equity does not need to be written down to be a legally binding contract. The verbal “he said / she said” model can be a disaster when it comes to stock deals, because your verbal commitments to issue equity could come back to haunt you, particularly if your company is poised to close a significant financing or sale transaction. Talk is not cheap, especially when informality or sloppiness gets in the way of the deals that you are working so hard to achieve.
4. Be Precise – Numbers are Nice
Whenever you agree to issue stock ownership, you must specify actual share numbers (which are static and unambiguous), and NOT just percentages (which require careful attention to detail and will change over time). It certainly is important to compute equity ownership percentages, because share numbers are meaningless without reference to your company’s overall capitalization. However, by expressing stock ownership with precise share numbers, you will avoid some difficult equity ownership situations (and potential disputes) in the future. For example, let’s assume that you have recruited a superstar engineer (we will call him Eric) away from Google. Eric is motivated to make the jump in part due to the prospect of having a significant equity stake in your company. You tell Eric that he will receive an equity award equivalent to a 2% ownership interest, but you do not formally issue the award at that time. Six months later, Eric has played a significant role in getting your product ready for launch and you start talking to investors about a large equity investment for a 20% ownership interest in your company. The investors ask you whether your cap table is “clean” and you realize that you never issued Eric’s equity award. You previously told Eric that he would receive an option for 2% of the company, but you did not specify how or when the 2% would be calculated. You now have to answer some questions that you could have avoided by dealing in numbers rather than percentages, including what outstanding share number should be used as the denominator? Should it include shares reserved for issuance under the company’s equity incentive plans? And, if so, should this number include the additional shares that will be added to the company’s equity reserve as part of the financing? Should it include the shares that the company will issue to investors in the financing? And finally, does the company need to refresh its stock option pricing valuation before issuing Eric’s award? Lastly, don’t make the horrible rookie mistake of guarantying a fixed ownership percentage of the company in perpetuity.
5. Make Every Vote Count
In an election year, we are constantly reminded of our right to vote. We also are bombarded with celebrity campaigns that encourage us to get to the polls and actually vote on election day, because the candidate with the most votes cast typically wins the election (please pardon the oversimplification). Voting also is essential in business, as a corporation’s stockholders must approve certain fundamental corporate transactions, including certain financing transactions and the sale of the company. However, unlike the general election for president, a company seeking authorization for a major transaction is usually required to obtain the approval of stockholders holding a majority or more of all outstanding shares. But how do you know with certainty that the transaction has been properly approved by a majority (or super-majority) of your Company’s stockholders if your company’s ownership records are in disarray? Take care of your business by taking care of business and making sure that your company has its equity ownership act together.
6. Investors and Acquirers Always Care
And so should you. Put simply, you can expect that all competent investors and acquirers will care (a lot) about equity capitalization. For example, properly structured equity investments are priced using a simple formula that is essential to the fundamental economics of the investment: ($) price per share = ($) pre-money valuation / pre-money equity capitalization. Similarly, acquirers expect to purchase 100% of the target company for one aggregate price in mergers and stock purchase transactions. In both cases, if the company’s equity capitalization is in question, then so are the economics of the deal. In some cases, equity capitalization issues are successfully resolved during the course of due diligence in financing and acquisition transactions, although these issues are always easier to fix before the transaction is underway. In other cases, equity capitalization issues that cannot be resolved easily can frustrate or derail these transactions. The takeaway is clear: you would be wise to proactively invest in and tend to your company’s equity capitalization early, often and comprehensively in order to avoid facing stock ownership problems that have become urgent and costly.
7. Don’t Reinvent the Pie
Get help if you have not maintained a cap table before. It is too important to your company’s success, especially if you are working towards a significant financing or acquisition/exit transaction. Also, if your company has a complicated equity capitalization structure and/or many investors, then you should consider investing in specialized cap table software or work with someone who has it.
Finally, don’t let your cap table become a crap table, such that you effectively are rolling your company down a craps table. As you start, fund and grow your business, you should find ways to mitigate unnecessary risk, and certainly not increase risk by failing to manage properly your company’s equity ownership.
Click here to get your very own equity financing model that can help plan your company’s next equity financing round.
How have you implemented the above best practices to maintain your company’s cap table? What equity ownership issues did you face and how did you resolve them? Help your fellow entrepreneurs and share your startup war stories to steer then in the right direction. Thank you for your participation.