Funding rounds and the impact on your cap table

As your private startup makes its way through the various funding rounds, you will need to be
aware of how that process can impact upon your cap table.

Maintaining a clean and clear record of ownership is important for any company, but arguably even
more so for startups either in the process of or looking to raise funds from outside investors. In that
situation, companies must be transparent with would-be investors who’ll want to see the ownership
structure recorded in a properly maintained cap table. Just as significant for a startup is to be able to
understand the potential impact that funding rounds can have in terms of how company stock is
distributed among relevant stakeholders and how each fresh injection of capital can affect the
ownership status quo.

Equity dilution

Each funding round will alter the existing ownership stakes. That brings with it equity dilution – as
more shares are issued the ownership percentage of existing stockholders will be affected, and
usually reduced. This is unavoidable up to a point, but companies still need to understand any
specific funding round is likely to impact on the existing ownership situation, partly with a view
towards updating the cap table, but also to keep current stockholders informed on how their holding
will be affected, and more broadly to understand the implications for overall control.

While, as stated, some measure of equity dilution is unavoidable when accepting outside
investment, you can look to minimize it in a number of ways, including:

• Don’t look to raise more funds than you need: Figure out what level of cash injection you expect you will need to take your company to the next level and let that inform your efforts to attract investment. In general, the more capital you accept from outside investors, the more that leads to equity dilution.
• Be strategic when choosing investors: Ideally, investors will have more to offer than just capital. If they also bring expertise and contacts etc., this could also impact directly on day- to-day operations and potentially help grow the company. The more you grow between funding rounds the more ability you will have to negotiate terms that help to minimize additional dilution.
• Fiscal responsibility: Be conscious of your cash flow. One of your challenges will likely be to find ways to grow while being as lean as is practical. Being conscious of cash burn without hindering your progress can help you avoid becoming over-reliant on outside investment over time.

A key point to bear in mind is that whether you keep equity dilution to a minimum or not, a top
priority should be to ensure that your cap table always offers an accurate record of the company’s
equity distribution.

In the context of funding rounds, a cap table can also be affected by:

Issuing of new share classes

At the risk of stating the obvious, new investors will receive stock in exchange for the capital they
pump into a startup.

Companies seeking funding may, upon securing board approval, create a new share class specifically
for the purpose of awarding that stock to new investors. Whatever changes the issuance brings
about will need to be recorded in the cap table to ensure that the ownership picture is up to date.

Investors will want to protect their investment as best they can. With that in mind, it is not unusual
for them to request preferred shares in exchange for their investment. Stock of this type offers
greater rights in the event of the company failing and also grants priority on receiving dividends.

Common stock offers fewer protections, but holders of shares of this type will have voting rights,
which is often not the case in connection with preferred stock.

Company valuation

Prior to a funding round, a company will usually undergo a valuation process to establish what it is
worth. This is vital, as that valuation provides investors with key information to guide their decision-
making process around how much capital they are willing to invest in the business.

From the startup perspective, the hope is that a funding round will ultimately lead to the company
valuation increasing. This can happen in different way. For example, a funding round deemed to be
successful can enhance how the company is perceived by market observers. On a more concrete
level, if a company is valued at €5 million and targets an additional €1 million, if the funding round
achieves that goal, then the company can now claim to be worth €6 million.

How a funding round impacts upon a company can also be influenced in part by where they are in
the life cycle. An early-stage company may be less likely to see a significant upward bump in its
valuation, as they are still developing and may be seen as a riskier prospect than a later-stage
company with a more established track record and evidence of growth to point towards.

However, the main point to emphasize for our purposes is that when the valuation of the company
changes, that impacts upon the stock’s value. Post-funding round, dilution might reduce the stake of
pre-existing stockholders in percentage terms, but the amount of stock they own may increase in
value. Such changes need to be recorded on your cap table.

Option pool

An option pool is a defined percentage of company stock ringfenced to be issued in the future as
options, usually with a view towards attracting talent.

The size of the pool will often become the focus of negotiations during a funding round, with
investors perhaps encouraging a larger pool (while not encouraging dilution or diverging from
market norms), with a view towards ensuring the company will be in a position to hire difference-
making personnel to help drive growth.

Early-stage startups typically set aside 10-20% of stock for this purpose, while later on, after making
key appointments, the pool size will normally be reduced to somewhere in the 5-10% region.

As more stock is released from the pool, this will have implications for dilution, which in turn means
that the company cap table must be updated to track these changes.

SAFE Notes

A Simple Agreement for Future Equity (SAFE) Note is a mechanism through which a startup looks to
raise funds from early investors, without handing over stock at the point the investment is made.
Instead, under the terms of the agreement, the conversion of a SAFE Note into equity will be
triggered by a future event, usually a later funding round.

With SAFE Notes, a valuation cap can serve to protect investors from excessive dilution in later
funding rounds, while a discount can ensure favorable terms compared to the prices paid by
subsequent investors.

As should be clear by now, when SAFE Notes convert into stock, that will have implications for the
overall ownership breakdown, which, in turn, will need to be recorded in your cap table if it is to
continue to be a reliable record.

Successful funding rounds are vital for startups as they look to grow. Securing outside investment is
in almost all instances going to be a prerequisite if companies are going to give themselves the best
opportunity for success down the line. To be credible with any potential investor, your cap table will
need to be in order. Each funding round will impact either directly or indirectly on the value of
company stock, which means your cap table will need to be maintained on an ongoing basis if it is to
offer an accurate snapshot of the ownership structure at any given moment.

Managing all of this on a spreadsheet or other manual solution can be not only time-consuming but
also leaves the information prone to human error, especially as you progress through funding rounds
and the details become more complicated. For this reason, many companies will seek out a software
or automated solution.

What next?

At J.P. Morgan Workplace Solutions we can provide the tools to help you effortlessly manage all your
equity, from inception to IPO and even beyond. Our cloud-based solution allows you to track
investors, model future funding rounds, and so much more, freeing you up to concentrate on driving
your business forward. What’s more our cap table offering is free for up to 40 stakeholders.

Talk to us today and see what our cap table services can do for you and your business.