Welcome to the third post of our Surviving Due Diligence series of tips and suggestions for startups exploring or undergoing investment rounds, exit conversations, and other transactions. Early-stage founders, particularly those without the benefit of a CFO, are often blindsided by issues that arise during diligence. These issues can jeopardize transactions and valuations and embarrass the founding team at exactly the moment they want to shine. Our advice? Forewarned is forearmed.
In startups, many diligence-related issues are errors of omission, not commission. They usually arise due to inexperience, neglect, lack of knowledge, bandwidth or resources, etc., not because the founders want to skirt the rules. In our two previous posts, we looked at Sales Tax and Employee/Contractor Classifications as two areas that consistently pop up as areas of concern. For this post, we will look at something more foundational to the business as a whole: Capitalization Tables.
What is a Cap Table?
A Capitalization Table (or Cap Table) is essentially the master ledger of who owns what equity in your business. Cap tables can range widely from the extremely simple to the highly complex, and they can become major headaches during a diligence process. Why? Because ultimately, anyone looking to acquire or invest in your company wants to know just how they and all your company’s current owners and investors will shake out when all is said and done – who gets what, how, when, and in what form.
Founders typically have a good grasp of their cap table in the beginning, i.e., the period after the company is initially formed, and ownership stakes are simple and straightforward. However, once external capital starts coming in—angel, seed or venture capital, SAFE or convertible notes, etc. —or once an employee option pool comes into play, cap table complexity will increase significantly. At this point, we often see the gaps that later turn up in diligence begin to form. Let’s look at a few of them in detail.
Cap Table Pitfalls to Avoid
By far, the most common issue we see involves basic documentation. Have you memorialized every equity owner’s participation in the business? Do you have those records executed by *all* parties, and are they organized and accessible? More than once, I’ve seen founders scrambling during a diligence process to find, replace (or in some cases, create) docs with investors, employees, co-founders, etc., that show up in cap tables. Make sure vesting, or the earning of options over time, is properly documented and signed by all parties. Be very careful with those handshake deals you make with early employees – if it’s not written down, it probably doesn’t exist from a cap table perspective. It’s very hard to rewind the clock once you’re in diligence.
Do yourself a favor – get ALL the documentation around equity ownership right from the outset, and even though it will come with a cost, don’t skimp on having legal counsel handle the docs. This sets up procedures and best practices for cap table updates down the road. Note: If you’re an LLC, this also includes updating the company’s operating agreement to reflect everyone’s equity percentages and interests.
2) Employees & Option Pools
One of the most important steps founders can take early in their company’s development is incentivizing their employees with stock, particularly early ones who often join at below-market salaries in return for equity. However, from a cap table perspective, properly tracking what happens to those option grants is crucial to a smooth diligence process later. Be sure to have proper records around plans, grants, vesting, option execution, and what happens to an employee’s options when they leave, so you don’t have to play catch-up during diligence. Another tip: Be sure to get new 409(a) valuations done after each investment round, material event, or twelve months from your last one.
3) Tax elections
A common misfire we see arise in diligence is failure of the founders and option holders to make timely 83(b) elections. 83(b) is a provision in the U.S. tax code that allows founders and other recipients of restricted stock or equity options to pay tax on the value of the stock on the date it is granted to you, instead of when it vests. This election is fairly simple to make but can save you and your employees significant taxes down the road because any appreciation in the stock will be treated as capital gains instead of ordinary income. What’s a “timely” election? You have 30 days after receipt of restricted stock or options to file the election with the IRS, which means by the time a diligence process rolls around, it’s far too late to take advantage of this feature. Check with your legal counsel, CFO, and/or tax professionals for more information.
As the complexity of a company’s cap table rises, so does the need to manage how a liquidity event would work its way through the various categories of equity that may have accumulated over time. For instance, a successful venture-backed company might have several classes of preferred stock, each with different rights and privileges, as well as a class of common stock in which founder and employee ownership resides. Some stakes may exist as convertible rights into one or more of these classes, and some may carry various preference claims over others. These waterfalls can become extremely complex and require time and precision to calculate correctly. Creating one in the midst of a diligence process can result in delays or, worse, mistakes in the flow of funds at closing.
We often encounter startups whose entire fully-diluted cap table is carried on a massive excel table or google sheet, replete with all the mistakes, mathematical errors, and missing information that often arise from multiple “owners” updating complicated documents over time. Do yourself (and your CFO) another huge favor: Get your company onto a cap table tracking platform like Carta, Pulley, or Shareworks sooner rather than later – these platforms automate, track and manage all the ins and outs of your cap table as you scale, including option exercises, waterfalls, documentation, reporting, scenario planning and, in some cases, those pesky 409(a)’s we mentioned earlier. Down the road, when you and your CFO are trying to do exit calculations for shareholders, you’ll be glad you did.
In deal diligence, we often see startups suffer from self-inflicted wounds that have little to do with their operations or growth prospects and could have been easily avoided if handled earlier. Cap table mismanagement is one of those wounds. Setting your cap table up for speed and scale at the outset is easily accomplished in a few hours with an experienced fractional CFO. It will almost certainly save you significant time, headache, and money down the road.