Equity Investing 101 - Understanding the Cap Table

A Capital Table is basically a financial statement that provides an assessment of the percentage of ownership of a business, equity dilution (or net worth), and potential value of equity during each round of financing by stakeholders, namely, entrepreneurs, investors, management members, and other ownership holders. All these terms pertain to an issued or outstanding stock certificate or partnership agreement. The document also includes the effect of control (or inability to acquire control). For ease of reference, the term 'capital table' refers to a financial statement that presents the equity holders' percentages of ownership in a business on a par value basis. It does not include the effect of dilution.

The purpose of the capital structure within any partnership agreement is to provide maximum flexibility for investors so that they may choose the best method for funding their capital needs. Within this capital structure, the primary function of management is to keep investors informed of their capital commitments and to minimize their risk by selecting investments that have a low risk to return but a high cap or price to cap. The cap table, therefore, serves as a tool by management to assist them in making these decisions. The cap table is an asset in itself because it gives information essential to the formulation of the overall capital structure and the partnership agreement. The basic purpose of the cap table is to provide a comparison of potential funding opportunities for partners to select the one with the highest potential return.

Partnerships operate under different capital structures. The partnership agreements can be classified as limited or common or, in partnershiphips that are more complex, into two types: active and passive. Under limited partnerships, the partners are limited to their own shares of the equity and have no voting rights; under common law jurisdictions, partnerships are generally considered to be active, where there is partnership interest with voting rights, i.e., one partner has a vote while the other has none; and, under the common law, passive partnerships give the partners no voting rights and are operated under a disregarded interest means. Capitalizing on these differences will help you decide whether the cap table is appropriate for your organization. However, one issue that must be addressed in the case of a partnership is the duplication of services provided by the partners in the same organization.

In the case of startup s, determining the appropriate cap table depends on the type of startup . An angel investor will want startups to include early stage technology companies because they are more likely to make large sums of money in the early stages. However, if the companies are later downsized and sold, the angel investors stand to lose far less money. Consequently, it is important to determine the exact amount of income that will be produced by the startups in order to determine the appropriate funding amount and cap table. The amount of money received should be approximately two to three times the amount of revenue earned by the company.

This means that the startup founders should only raise equity from investors who can guarantee them at least ten percent of their capital. In addition to this requirement, the equity fund managers will require startup founders to give them the option of investing additional money in exchange for shares in the company. This makes the capital raise acceptable to both the investors and the startup founders. In other words, if the startup founders want to raise more money, they can do so through equity injections from external sources. However, if they want to expand their current business, they cannot raise additional capital using equity injection methods.

Unfortunately, cap tables that are based on equity injections are really confusing. Some people believe that if the company has only a small amount of equity, the capital will not be as expensive as it looks like. This is not always the case because the business may be growing faster than the equity in the company. While equity injections can be expensive, they can also be a really helpful source of extra capital if they are properly structured.

Equity from venture capitalists will be especially useful because they have access to start-up companies that are valued in the capital markets. Capital from these investors will be tempting to initiate financing for a business as long as the company does not yet fulfill its claims on the equity. Therefore, this type of capital is actually a form of "captive audience" funding. The fact that the venture capitalists own shares in the business will make it difficult for the business to claim ownership of all the equity in the company. This means that any potential valuation of the company will depend on the equity holders signing individual shareholder agreements.

Many start-ups want to raise capital but are confused about the equity structure and cap table. In reality, there are only two factors that really matter in determining the valuation of any given company: the founders' and the company's equity positions. The cap table really just serves to provide an accurate comparison of the value of a start-up with the valuation of similar businesses in the private equity capital markets. The value of the company really depends on whether the entrepreneurs are capable of raising the capital that they need and on the extent of their individual risk tolerance.