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A recurring topic of conversation we have here at Capdesk is, unsurprisingly, that there's a need for companies to be more knowledgeable about the capitalization table, also known as a ‘cap table'. We see ‘broken' cap tables all the time and, more often than not, companies make mistakes in their shareholder registers or employee share plans because of that. These mistakes can sometimes cost businesses millions of pounds. And, for the record, if you're curious about what kinds of cap table management errors we see in the hundreds of companies we help, you can read all about it here.

Oftentimes, it can be difficult to fully grasp the severity of consequences we have not personally experienced. That's why, unfortunately, many businesses don't understand just how important it is to pay huge attention to details of ownership until they reach a crucial stage in their journey (such as an acquisition), by which point it's too late to prevent the chaos resulting from mistakes in equity reports. The cap table is the cornerstone of all equity reports and filings, as well as an important part of any company throughout its life - from formation to exit. It's the database in which rights to the company's value are listed and, as we will illustrate over the next few chapters, it's not always easy to understand how cap table decisions affect the company stakeholders. In our exploration of the topic, we will mainly focus on understanding cap tables for UK companies, but some references will be made to European norms in general.

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1. Company Formation

The first time that a founder will have to make decisions which will affect the company cap table is when forming the company. In most jurisdictions, a company entity is necessary for the founder to provide services without personal liability and to operate with VAT. To form the company, the founder has to make several decisions regarding the company's shares and share capital, as well as produce articles of association.

Further reading on company formation:

Crunch gives a summary of reasons to start a limited company in the UK.

Shares and Share Capital

First, the founder has to decide how many shareholders will be involved in the business. If the company expects to receive investment at a later stage, it should consider issuing plenty of shares already from its formation. This can solve the need for corporate actions (and the admin work that comes with it) later on, such as doing a share split, whereby existing shares are multiplied and share certificates re-issued.

The number of shares issues per shareholder, as well as the individual share's nominal value, will vary from business to business. Note that shares are issued against capital investment, which means the founding partners will have to invest an amount corresponding to the number of shares multiplied with the nominal share price. In the UK, shares can be issued at a nominal value of 0.000001 (six decimals), so a company can be founded with 1,000,000 shares against a capital investment of £1.

The £1 capital requirement in the UK is quite generous to entrepreneurs. In countries where capital requirements are higher than £1, it's worth to remember that the capital invested in the company formation will be recorded on the balance sheet and can be used in the company's operations.

Share Classes and Share Rights

When decisions have been made regarding the number of shares and capital investment, it's time to consider share classes (i.e. types of shares) and the share rights that come with each of these. From a legislative perspective, there are no limitations to the number of shares or share classes a company can issue, but best practice is to keep things simple and incorporate the company with a single share class. The company can soon enough have a need for more share classes, especially if the strategy is to build the company with venture capital investment. For example, a venture capitalist (VC) will often insist on a new class of shares with specific rights when investing (which we will get back to in chapter Series A negotiations), so it's smart to start with as few classes as possible to avoid your equity structure becoming overly complicated down the road.

Indeed, most companies will incorporate with a single class of shares, called ‘ordinary shares' (the name can be changed later if there is a need for it). An ordinary share will assign shareholder voting rights and dividend rights, also known as share rights. Voting rights means the right to vote at the company's general assembly, and can be assigned with any multiple. Some ordinary shares can have one vote, while others may have 10. Dividend rights mean the shareholders right to participate in the company's profits.

Articles of Association and Memorandum of Association

In the UK, the thoughts and decisions regarding the number of shares and share rights should result in two documents necessary for formalising the company formation - the articles of association and a memorandum of association.

A company's articles of association constitute a document defining its purpose and regulating its operations. Share classes, share rights, and share capital are defined in the company's articles of association as all have an effect on how different tasks are to be performed within the organization.

A memorandum of association gives an account of the subscribers participating in the company's formation. More specifically, the document includes the name of the company, the name of its subscribers, as well as each subscriber's signature.

Once these documents are formalised, the company can officially be formed and start issuing shares.

Primary Transactions: Issuing Shares

A share issuance, (often used interchangeably with the term ‘share allotment'), is a common way for businesses to raise funds or otherwise benefit the business (e.g. offer them as an incentive to recruit key employees). To issue shares to a new shareholder, the first step is to simply offer them to that person verbally or, more formally, in writing. The recipient must then fill out an application for new shares (normally provided by the company) and return it along with the relevant payment for the shares they wish to buy.

The company must then host a board meeting, where all potential shareholders' applications are reviewed, and a decision is made about what shares will actually be allotted and to whom. The meeting's final decisions must be formally reported in a document called ‘board resolution'. The exact contents of this may vary, but as a minimum it should outline the number and nature of shares issued and to whom, specify the forms that need to be submitted to Companies House following the issuance, authorise the issuance of share certificates to the new shareholders, and highlight the updates that need to be made to the company's register of members and register of allotments.

Following that, a business in the UK will have to issue share certificates to its new shareholders. This should be done as soon as possible, and no later than two months after the share allotment, because a share application usually only becomes binding once the applicant becomes notified that his or her application was accepted. Therefore, in theory, the company could end up issuing shares and have the applicant withdraw their application shortly after, creating a bureaucratic headache for management.

The next step is filing an SH01 to Companies House, to notify them about the company's current capital structure and any amounts that have potentially not been paid on them.

Finally, the register of members and register of allotments will have to be updated to reflect all new share issuances. Technically, new shareholders are officially recognised as such when they've been added to the company's shareholder register. Note that, in the UK, the company is legally obliged to register its new shareholders no later than two months after its board resolution meeting. The register of allotments must also be updated to reflect the details of each individual share issuance - in other words, even if shares are issued to an existing shareholder within the company, the business still needs to update its register of allotments to illustrate the new shares this person received.

Share Issuance

As a side note: even though the company doesn't need to worry about this right away, it will ultimately have to provide the details of its new shareholders when filing its Annual Confirmation Statement (i.e. CS01) to Companies House. To read more on how to file a confirmation statement, take a look at our relevant guide.

The Company's First Cap Table

In the following example, we'll form a company with two equal co-founders. Each will receive 100,000 ordinary shares on a nominal value of £0.01 in exchange for an investment of £1000. The company will now have two shareholders, 200,000 shares outstanding (i.e. the total equity held by the stakeholders), and a share capital of £2000.

Shareholder Ordinary shares % Ownership £ Value
Founder I 100,000 50% £1000
Founder II 100,000 50% £1000

2. Seed Round

The term ‘seed round' is used to indicate an early investment in a startup company which is made before the company has any revenue and often before there's even a product available.

A seed round investment is usually considered to be a high risk investment. Due to this high risk, investors in seed companies are often private individuals with good knowledge of the founding team or by industry experts with good domain knowledge. Such individuals are commonly known as business angels or angel investors.

Not every company will need equity investment from an external investor, but it's very common in businesses with high start-up costs, long route to first revenue, and few tangible assets (such as manufacturing tools) which can be used as leverage in loan financing.

The company's cap table will be affected by the seed round when new shareholders or debt holders are investing in the company and is central of deal preparation, negotiation and valuations.

Valuation Pre-Money and Post-Money

Valuations can be tricky, especially in the early days of a company's life where there are few or no tangible assets. At this stage, a valuation is more art than science and it's the result of negotiations between the investing and issuing parties. Parameters to consider when setting a company valuation is the valuation of comparable companies and the future capital requirements of the business. A company with high capital requirements should generally be valued higher, in order to account for further dilution before reaching profitability. In the following example, we'll use a £1 million investment into the company at a £4 million pre-money valuation.

Deals like this are usually agreed on a pre-money basis. Pre-money means the valuation of the company before any new cash has been invested. Post-money means the valuation after the money has been invested. It is important that the parties are aligned and explicitly agree on the valuation. As this example shows, the difference between pre and post-money is quite severe for both parties:

Investment Dilution % - percentage
£1M at £4M pre-money 20%
£1M at £4M post-money 25%

The valuation discussion is important to the founders whose initial £2000 investment now has a paper value of £4,000,000. That's a great return after a couple of months working on a good idea. It's therefore crucial to consider “paper value” - the shares are worth nothing before materialisation. As we shall see in the following paragraphs, the initial share value registered on the cap table will go through numerous stages and changes before the company reaches an exit.

Option Pool Shuffle

When negotiating their seed funding, companies often face the challenge of forming a solid strategy to attract new talent that will contribute to building and scaling the business. In a company's early days, it is often impossible to compete with established businesses based on salary, so founders have to approach recruiting in other ways. For example, they can offer attractive working lifestyles, flexible working hours, better company culture, or promise share options and thereby give employees the opportunity to participate in the company's value. At this stage, a company will typically issue 10%-15% of its total share capital to the option pool - also referred to as an ‘equity pool' to denote the inclusion of other equities, such as warrants.

The option pool shuffle relates to a question of how many shares will be ultimately allocated to investors when the company also creates an option pool to reserve shares for employees. In terms of the above, there are two different approaches to creating an option pool: the Investor Friendly Approach and the Founder Friendly Approach.

The Investor Friendly approach, which is also called a ‘pre-money pool', gives the investors a greater share of the company. In this approach, employee share options are allocated first, and then the investor is allocated his or her shares. As a result, the investor share allocation dilutes the share option pool, and therefore the VC ends up with a greater percentage of the company.

The Founder Friendly approach, also known as a ‘post-money pool', is the opposite way of issuing shares to investors and ultimately gives them a smaller share of the company. The investor is allotted shares first, and the option pool is created subsequently. The effect of this is that the investor's shares are diluted by the new pool and he or she therefore ends up with a smaller percentage of the company.

Option Pool Shuffle

In the following section, we will illustrate the difference between the two approaches. In our example, before receiving its £1 million investment the company's total number of shares is 200,000 with a pre-money valuation of £4 million. The option pool will be 10%.

The Founder Friendly Approach

Allocating shares based on a founder-friendly approach, the company is issuing shares to the investor before creating the employee option pool. To find the number of shares issued to the investor, we have to first find the share price: Pre-money valuation £4,000,000 / Shares outstanding 200,000 = £20.00 per share.

The number of shares can now be determined, by dividing the investment amount £1,000,000 by the share price of £20.00 = 50,000 shares.

Creating the option pool following the allocation will then result in 27,778 shares (10% of 277,778 shares the new total number of shares) and dilute the investor's position to 18% ownership (50,000 / 277,778 = 18%).

Shareholder Ordinary shares % Ownership £ Value
Founders 200,000 72% £4,000,000
Seed Investor 50,000 18% £1,000,000
Option Pool 27,778 10% £555,560
Total 277,778 100% £5,555,560

The Investor Friendly Approach

An experienced investor will most likely ask the founders to take an investor-friendly approach and issue shares to the option pool before investors so that the option pool will total 10% post-money.

In this scenario, the company will issue shares to the option pool and then to the investor. To calculate the allocations, we first have to set a share price for the round. The price is calculated as pre-money valuation / (shares outstanding + options). Since the option pool allocation and the investor allocation are both linked to the post-money total number of shares, we'll have to make assumptions so that the option pool becomes 10% or close to post-funding. In this example, the assumptions lead us to a share division of:

Shareholder Ordinary shares % Ownership
Founders 200,000 70%
Seed Investor 57,142 20%
Option Pool 28,152 10%
Total 285,644 100%

We can use the allocation to calculate the share price: Share price = pre-money valuation of £4,000,000 / (issued shares 200,000 + option pool shares 28,152) = £17.500033

The price per share can be used to compute the investor's real investment size based on £17.500033 * 57,142 shares = £999,987 investment.

Shareholder Ordinary Shares % Ownership £ Value
Founders 200,000 70% £3,500,007
Seed Investor 57,142 20% £999,987
Option Pool 28,571 10% £499,993
Total 285,713 100% £4,999,987

As the comparison between the two approaches reveals, the option pool has a significant effect on the founder's share value which has dropped from £4,000,000 in the founder friendly scenario to £3,500,0000 in the investor-friendly scenario. Further, while the investors share value remains the same in the two scenarios, the number of shares allotted increase by 7,142 shares. This difference will have a significant effect on the investor's position later on.

The Company's Second Cap Table

Following the seed round, the company will issue new shares and update the cap table. The option pool will be included in the cap table's fully diluted ownership, but will not have the right to exit proceeds before the option is in the hands of an option holder with the right to exercise. So until the company starts granting options, all capital proceeds will be shared between the founders and its investor.

Shareholder Ordinary Shares % Ownership £ Value
Founders 200,000 70% £3,500,007
Seed Investor 57,142 20% £999,987
Option Pool 28,571 10% £499,993
Total 285,713 100% £4,999,987

3. Employee Equity Remuneration

After concluding the funding round, our example company has enough cash to start recruiting employees to help build the business. It has even made the option pool as requested by the seed investor, and will actively be using options to align the team and mitigate some of the salary competition. But, what kind of securities should it be issuing and how many? There is a number of securities that could be considered here, but in this chapter we'll be looking closer into stock options, warrants, and phantom shares in particular.

Stock Options, Warrants and Phantom Shares

Stock Options

A stock option, or share option, is a contract that gives the recipient (usually an employee) the right to purchase shares in the company at a specified price (also known as the “strike price”) by a specific date. The employee is under no obligation to buy, or “exercise”, any or all of his or her options. Typically, but not always, options will “vest” over time. In other words, the employee will not be able to exercise his or her options straight away, but will have to wait until a specific point in time whereby some or all of the options have vested - i.e. have become exercisable. If an employee leaves the company or is fired, they typically have 90 days to exercise their unexercised options that have vested or they implicitly forfeit them. Employees will typically forfeit any unvested options.

Time-Based Vesting Schedule with Cliff and Equal-Sized Tranches

Unlike shares, options aren't taxed until they are exercised, so long as they were issued at or above the fair market value of the underlying shares. Options, though not actually shares, are typically counted as part of the “fully diluted” shares of a company.

Companies establish share option programs as part of an overall employee compensation plan for several key reasons. Notably:

  • Option programs can boost employee morale and help attract talented, high-skilled workers who are motivated to help the company improve and succeed.
  • Employees holding options to purchase shares feel more like owners or partners in the business and are invested in the company's success.
  • In addition to being a benefit for employees, share option plans are cost-effective for companies with the only significant costs to the company being the lost opportunities to sell some shares at market value in the future and the expense of administering the plan.

Options are a key currency in early stage companies, who often make a bargain with staff of below-market/lower cash compensation in exchange for a share of the company's future success. It's a critical incentive to attract talent while the company is still cash poor.

Warrants

A warrant is similar to options - i.e. contractual rights for investors or other third parties to buy stock in the company at an agreed price within a set timeframe. However, it differs from options in that it's not issued through the company's option pool. Nevertheless, the board still has to approve allotment of warrants. In some jurisdictions - mainly continental Europe - warrants are often preferred over options as a security for employee remuneration, due to tax considerations.

In early-stage deals, companies can offer warrants as an incentive for investors to invest sooner rather than later, given that warrants allow investors the opportunity to ‘top up' their initial investment at the same price in the future, thereby reducing the risk of that investment. This practice is often combined with the issuance of convertible notes. The combination is particularly attractive to investors because warrants represent an upside appreciation without any capital commitment, while convertible notes are a loan that often carries interest. As a result, investors are protected as debt holders - i.e. they get cash back before shareholders if the company is liquidated or have considerable risk-free upside if the company becomes successful.

The value of warrants for their holder is the difference between the exercise price (strike price), which is typically set at fair market value on the day of issuance, and the fair market value of the company's share price on the day of exercising. For example, a warrant with an exercise price of £10.00 which is exercised at a share price of £100 represents a £90.00 gain. The warrant holder will look for the share price to exceed the exercise price before the expiration date to get the benefit. If the share value has not exceeded the exercise price, the warrant is rendered worthless and the holder can simply allow it to mature without exercising. It's important to note that the gain does not necessarily materialise in the form of cash at the time of exercise, but can also simply become shares.

Most warrants have long expiration dates - expiration terms of up to 10 years into the future are common. Investors are not required to exercise warrants but, as mentioned already, they will become worthless once they expire unexercised. Companies do not have any responsibility to remind investors about the warrant expiration dates, so if you are investing in a company through warrants it's a good idea to set a reminder about the expiration date.

Phantom Shares

Don't let the name to mislead you - a phantom share is neither a share nor an option. It is a cash bonus plan that ‘walks and talks' like a share option plan. A phantom share option will never result in the company issuing an option to the holder, but the amount of the bonus is tied to the number of vested options and market value of the company's shares.

In a phantom share plan, the recipient is granted an option over a number of shares at a pre-set option price which is usually - as it is with options and warrants - the company's share's market value at the date of the grant. The option will vest over time so that the holder's rights to bonus increase over time to reflect the fact that he or she has contributed to the value of the company. Upon exercising the option, the holder receives a cash bonus equivalent to the difference between the market value of the shares at the time of exercise and the option price.

For startups, phantom shares are a flexible way of involving employees and advisors in the growth of the company with less legal and tax work compared to options and warrants. They are widely used in countries such as Germany, where tax legislation is strict on equity remuneration. The downside to phantom shares for the recipient is that any resulting gains will be subject to income tax rather than capital gains tax, which is often a higher tax bracket.

Equity and Cash Split

How many options should a company give employees and what is the optimal split between cash and options to ensure employee motivation? The internet is full of advice and calculation methods for distributing the optimal number of share options. In reality, the answer is that there is no recipe. It's all up for negotiation between each particular company and its employees.

From a company's point of view, options are a great way of remuneration. The employee has to buy the option at exercise price and is only compensated for the value they help create for the company. It's cheaper than cash, and simultaneously helps align the team towards one common goal. For the employee, options represent a potential asset that can be worth much more than a salary. For example Facebook's IPO created more than 1000 new millionaires and multiple other IPOs have the same for employees. However, the key word for employees in this discussion is “potential” benefit. There is no guarantee that the options will ever actually materialise into cash. So how can the company and employee achieve a good balance between professional and financial benefits?

In our example company, the founders are looking for the best available talent, quickly realising that the best people already have jobs - well-paying jobs! They receive a lot of interest from candidates who are interested in swapping their corporate job for a startup lifestyle, but the salary package can be a limiting factor for some candidates. The solution for these cases is issuing options. The new employees can afford a small cut in salary against an upside in options. By using options the company can sell the entrepreneurial dream, being part of the team and the potential of participating in a big exit someday in the future.

4. Convertible Note

In this chapter, we will explain what a convertible note is, when a company should consider raising money on a convertible note, and how it affects the cap table.

Standard Convertible Notes

A standard convertible note is a form of short-term debt that converts into equity, typically in conjunction with a future financing round. Here's how it works: the investor loans money to a company, which can carry interest, although not always. When paying back the loan's principal plus interest (if any), the company can pay the investor back with either cash or equity, in the form of shares. A convertible note holder does not have voting rights in the company before the note has been converted. A standard convertible note agreement will usually stipulate terms like:

  • Discount Rate A valuation discount which noteholders will receive relative to investors in the future financing round, which compensates the note holder for the risk of investing earlier.
  • Valuation Cap The highest possible company valuation at which the note can be converted into equity. It protects convertible note holders if the company raises its next round at a valuation that exceeds the valuation cap.
  • Interest rateStandard convertible notes typically accrue interest on market terms. It is a compensation to the investor for the time the note is outstanding. Accrued interest will be added to the principal and increase the number of shares issued upon conversion.
  • Maturity DateThis denotes the date on which the note is due, at which time the company needs to either raise qualified financing or repay the note.
  • Qualifying FinancingAn amount invested in a future funding round which will provide the company with a decent runway and will trigger the conversion of the note.

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SAFE Note

A SAFE (simple agreement for future equity) note can substitute a convertible note, but is often considered as a simpler solution in the sense that it takes the form of a five-page document, where no terms other than the valuation cap and discount rate are negotiable. SAFE notes were initiated back in 2013 by the accelerator Y Combinator, with the aim to simplify the process of raising seed funds for startups, by removing interest rates and maturity dates from the agreement.

Although SAFE notes are convertible security (i.e. they can convert into shares later on), they are different from convertible notes in that they do not create debt and mount up interest. Similarly to options, a SAFE note simply offers its holder the opportunity to buy shares at some point in the future, typically at a discount.

There are four types of SAFE notes:

  1. Valuation cap, no discount
  2. Discount, no valuation cap
  3. Valuation cap and discount
  4. No valuation cap, no discount, most favoured nation (MFN) clause.

While SAFE notes offer companies and investors a faster, more affordable way to complete transactions - which might be a great advantage, especially in the early stages of a startup - they offer less flexibility and potential for future negotiations. That's why opinions vary about whether they are preferable to convertible notes, and one could argue that this depends on the interests of the specific investor and/or company.

Further reading on SAFE notes:

If you'd like to dig a little deeper on the topic, Upcounsel gives some great insights here.

Advanced Subscription Agreement

An Advanced Subscription Agreement (ASA) is used in the United Kingdom, and also resembles the convertible note but this time in terms of being treated as debt on the balance sheet until a company's next funding round. Both documents constitute an equity agreement, however unlike convertible notes ASAs cannot be paid back in cash, do not carry interest, and do not need to be repaid within a fixed period of time. They are simply a way for investors to pre-pay for shares that will be issued during a future funding round at a discount.

The main benefit to investors is that ASAs can qualify for SEIS/EIS treatment, giving investors a tax incentive to buy into the company. In order to qualify for SEIS/EIS the ASA will convert into ordinary voting shares.

Investors normally receive the shares they are entitled to during the company's next funding round, provided that the company reaches a certain target that has been predetermined in the ASA. If the company does not reach this target, then the investor receives his/her shares by a certain ‘ultimate' date - formally known as the Long Stop Date - and the number of shares he/she will be allocated is determined by a certain fixed price - known as the Long Stop Price. Both Long Stop Date and Long Stop Price are agreed upon from the beginning in the ASA.

In the event that the company becomes insolvent before the qualifying funding round, the investor might be paid back in cash. If the company is sold before the qualifying funding round, shares will normally be issued right before the funding round at the sale valuation or at a discount. In all three scenarios, the exact way of compensating the investor depends on what has been predetermined in the terms of the ASA.

When to Use a Convertible Note

A convertible note is used when a company and investors cannot agree on a valuation for the company. There can be multiple reasons for this. Typically if a company is at a very early stage (for example, idea stage), it can be difficult to agree on a specific valuation and thus smart to postpone the decision until a later funding round when the company has matured. It can also be the case that a company has urgent capital requirements or needs a little extra runway to achieve the next stage of development. Using our company as an example again, a likely scenario for a convertible note could unfold as follows:

Following the Seed Investment, the company had budgeted with a runway of 18 months to reach Series A. They have hired the first employees, the product is on the market, and they have some initial customers. But after 12 months, it appears that they are falling a little behind targets. Accepting that they cannot achieve Series A with the desired metrics and likely not at the desired valuation, they decide to postpone until the business metrics are in place. Management thinks they will need an additional 6 months and £1 million to achieve the desired milestone. This is obviously an issue that has to be addressed. A bank loan is not feasible with small revenue and large cash burn. Equity investment would require valuing the business and could set a benchmark for the upcoming Series A. As a result, attention falls onto a convertible note.

The same category of investors who showed interest in the first round will usually have an interest in a convertible note at this stage. The company has matured a bit and thus reduced investment risk, but there is still an opportunity to get in before Series A at a lower valuation. Knowing this, the company is assisted by its seed round investors with introductions to potential new investors. They quickly get a couple of offers from investors who are interested in investing £1 million through a standard convertible note with 5% annually compounding interest rate on a day model with 365 days/ year. The valuation cap is set at £10 million and a 20% discount rate to the next investment.

The Company's Fourth Cap Table

Accepting an offer from a seed extension investor, the company now has the 4th version of their cap table. Notice that the convertible note is listed as debt on the balance sheet and does not yet have any equity ownership. Further, employees have now vested options which are the options that have been issued from the option pool and now can be exercised by employees. The company can choose to issue more shares to the option pool when all options have been granted to employees.

Shareholder Ordinary Shares % Ownership £ Value
Founders 200,000 70% £3,500,007
Seed Investor 57,142 20% £999,987
Employees vested options 20,000 7% £350,000
Option Pool 8,571 3% £149,993
Convertible note 0 0% £1,000,000 + interests
Total 285,713 100% £4,999,987

5. Series A

‘Series A' refers to a company's first venture capital investment round. The term is meant to reflect the first issuance of preference shares - preferred A shares. In this chapter, we will take a close look at the Series A term sheet, negotiations, and preferred shares.

Our company is now performing really well, growing fast, and sees several venture capital funds showing interest in investing. The company is generating revenue, but is not yet cash-flow positive and will need a boost to achieve ambitious growth plans. The management decides it's time for a Series A. The ambition is to raise £15M at a £20M pre-money valuation to fuel international expansion.

Three VCs are expressing interest to invest; the VC with most domain knowledge is appointed to be lead investor. The lead investor will be responsible for negotiating the investment deal terms with the company on behalf of all the investors. A VC round is more complex than the angel rounds which the company has prior experience with and which can be closed with a simple handshake. VCs are complex entities, with investors of their own, and have to go through a strict selection process before any capital is committed. The first step for a company raising VC money is to attract the attention of one partner. If the partner likes the business and its potential, they will present it to the other managing partners. The company will often be invited to present the business in front of the partners, and if all partners agree on the business they will proceed to the term sheet stage.

Term Sheet

A term sheet is a nonbinding agreement setting forth the basic terms and conditions under which an investment will be made. A term sheet serves as a template to develop more detailed legal documents. The key here is to agree that the parties will negotiate and invest legal resources in a deal.

The company can bring their own term sheet, but most often the VC will bring their term sheet to the deal. The term sheet will typically map out a time frame within which the parties involved will negotiate between them, and not negotiate with any other parties.

One of the tasks at hand during the term sheet stage is to present a cap table for the investment round - both pre- and post-money. To do so, the company first has to make a new pre-money valuation and convert the outstanding note.

Converting the Note

The first step in organising cap table scenarios for the round is to convert the note from debt to equity. The note has accrued interest over the last year and the initial loan of £1,000,000 has grown with £50,280.75 to £1,050,280.75. The updated cap table is looking like this:

Shareholder Ordinary Shares % Ownership £ Value
Founders 200,000 70% £3,500,007
Seed Investor 57,142 20% £999,987
Employees vested options 20,000 7% £350,000
Option Pool 8,571 3% £149,993
Convertible note 0 0% £1,050,280.75
Total 285,713 100% £4,999,987

The company had agreed a valuation cap of £15,000,000 with their investor. This is the highest valuation that the loan can be converted to. It was also agreed to implement a discount of 20% on all valuations lower than £15,000,000.

The Series A investors will invest in the company at a pre-money valuation of £20,000,000. Alas, the new valuation is higher than the valuation cap for the convertible note and thus triggering the conversion of the note from debt to equity at £15,000,000. The discount would only kick in at valuations under the cap and is no longer eligible for conversion.

To calculate the number of shares after conversion, we need to find the pre-money share price. This can be done by dividing the valuation cap by the total number of shares: £15,000,000 / 285,713 = £52.50 per share.

Knowing the share price, we can now divide the investment amount by the price per share: £1,050,280.75/ £52.50 = 20,005 shares after conversion.

Shareholder Ordinary Shares % Ownership £ Value
Founders 200,000 65% £3,500,007
Seed Investor 57,142 19% £999,987
Employees vested options 20,000 7% £350,000
Option Pool 8,571 3% £149,993
Convertible note 20,005 7% £1,050,281
Total 305,718 100% £6,050,268

Convertible Note Shuffle

We previously explained the option pool shuffle. “Convertible debt shuffle” is a similar phenomenon which can appear in relation to the conversion of convertible notes. In short, the convertible debt shuffle impacts the shares allocated to an investor, when a convertible note conversion is triggered by an investment. Like the option pool shuffle, there are two ways to determine the shares to be allocated and the price paid per share. Let's see what happens to the allocation of shares to our new investors in two different scenarios:

The Investor Friendly Approach

The company converts the debt round first, allocating their shares using the number of shares outstanding. Then, using the revised number of shares outstanding, they allocate the new investor their shares, based on the amount they've invested.

We already converted the debt note earlier, which led us to the following cap table:

Shareholder Ordinary Shares % Ownership £ Value
Founders 200,000 65% £3,500,007
Seed Investor 57,142 19% £999,987
Employees vested options 20,000 7% £350,000
Option Pool 8,571 3% £149,993
Convertible note 20,005 7% £1,050,281
Total 305,718 N/A £6,050,268

The new investment of £15,000,000 at £20,000,0000 pre-money will result in: pre-money valuation £20,0000,000 / outstanding number of shares 305,718 = £65.21 per share.

The conversion of the note results in a lower price per share than if the note had not been converted. Now the £15M investment is calculated as £15M / £65.21 = 223,469 new shares.

This leads to the following ownership percentage for the investor-friendly approach:

Shareholder Ordinary Shares Preference shares % Ownership £ Value
Founders 200,000 - 37% £13,041,508
Seed Investor 57,142 - 11% £3,726,089
Employees vested options 20,000 - 4% £1,304,151
Option Pool 8,571 - 2% £558,894
Convertible note 21,000 - 4% £1,369,358
Series A - 230,035 43% £15,000,000
Total 536,748 - 100% £35,000,000

The Founder Friendly Approach

The company allocates both the convertible debt and the new investor shares based on the same amount of shares outstanding. To calculate the allocations through this method we will use the cap table pre-note-conversion.

Shareholder Ordinary Shares % Ownership £ Value
Founders 200,000 70% £3,500,007
Seed Investor 57,142 20% £999,987
Employees vested options 20,000 7% £350,000
Option Pool 8,571 3% £149,993
Convertible note 0 0% 1,050,280.75
Total 285,713 100% £4,999,987

The new investment of £15,000,000 at £20,000,0000 pre-money will result in: pre-money valuation of £20,0000,000 / outstanding number of shares 285,713 = £70.00 per share.

The Series A investor will convert using the following formula: £15M / £70 = 214,285 new shares.

We also have to convert the outstanding convertible note, which is done by using the valuation cap share price of £54 and converting the outstanding debt. So £1,102,500 = 20,400 new shares.

This leads to the following ownership percentage for the founder friendly approach:

Shareholder Ordinary A Preference A % Ownership £ Value
Founders 200,000 - 38% £14,000,063
Seed Investor 57,142 - 11% £3,999,958
Employees vested options 20,000 - 4% £1,400,006
Option Pool 8,571 - 2% £599,973
Convertible note 21,000 - 4% £1,470,007
Series A - 214,285 41% £15,000,000
Total 520,998 - 100% £36,470,007

To sum up: in the VC friendly approach the VC ultimately received more shares; in the founder friendly approach, the VC gets fewer shares. So how does one decide which one to choose? The answer is that it depends on negotiations and the investors approach. We've listed some different opinions in the section below.

Further reading on convertible debt:

Take a look at AVC's explanation of the subject.

Series A Negotiations

With an understanding of the two methods of debt conversion and their impact on ownership, the founders evaluate the best approach for them. They decide to take the founder friendly approach and negotiate the deal from that standpoint. So the post-money cap table scenario sent to the investors is:

Shareholder Ordinary A Preference A % Ownership £ Value
Founders 200,000 - 38% £14,000,063
Seed Investor 57,142 - 11% £3,999,958
Employees vested options 20,000 - 4% £1,400,006
Option Pool 8,571 - 2% £599,973
Convertible note 21,000 - 4% £1,470,007
Series A - 214,285 41% £15,000,000
Total 520,998 - 100% £36,470,007

The Series A investors are very experienced and doing several funding rounds every year. They immediately notice the conversion when receiving the cap table, and have a prepared response: preference shares with participation rights and liquidation preferences. A preference share refers to share classes with a set of preferences to a company's capital. Preference shares usually do not have voting rights, but instead come with liquidation preference - meaning first rights to monies coming out of a company when paying out dividends, exit proceeds, or leftovers after liquidation.

Shareholder Ordinary shares Preference shares % Ownership £ Value
Founders 200,000 - 38% £14,000,063
Seed Investor 57,142 - 11% £3,999,958
Employees vested options 20,000 - 4% £1,400,006
Option Pool 8,571 - 2% £599,973
Convertible note 21,000 - 4% £1,470,007
Series A - 214,285 41% £15,000,000
Total 520,998 - 100% £36,470,007

Preference shares are standard in VC deals. VC investing is about beating the odds and finding the unique investments that can pay back 10, 50, or 100 times the initial investment. However, it's also about protection against bad investment outcomes through provisions, such as liquidation preferences.

The investors are looking to commit £15 million in the company, and insist on a liquidation preference with 1x multiple and participation rights. This will ensure that the investor is paid the first £15 million in the event of exit or winding up of the company. They will also participate in monies paid out after the first £15 million on an equal basis with other investors. Let's take a look at outcomes in the event of selling the company at different valuations:

Worst Case Scenario

Exit: £0 - £15,000,000
Shareholder Ordinary Preference A % Ownership Monies out
Founders 200,000 - 38% £0
Seed Investor 57,142 - 11% £0
Employees vested options 20,000 - 4% £0
Option Pool 8,571 - 2% £0
Convertible note 21,000 - 4% £0
Series A - 214,285 41% £0 - £15M
Total 520,998 - 100% -

The worst case is the company going under and having to liquidate. The VC's will get all proceeds up to £15M. In this example everybody is losing, but the VC at least has some downside protection. Nobody wants this.

Bad Case Scenario

Exit: £0 - £35,000,000
Shareholder Ordinary Preference A % Ownership Monies out
Founders 200,000 - 38% £7,826,621
Seed Investor 57,142 - 11% £2,225,656
Employees vested options 20,000 - 4% £432,662
Option Pool 8,571 - 2% £0
Convertible note 21,000 - 4% £1,168,788
Series A - 214,285 41% 23,346,273
Total 520,998 - 100% £35,000,000

Although this is a better situation than the worst case scenario, it is still a suboptimal result for VCs - i.e. a company where growth stagnates and the value does not increase post-investment. In this case, the liquidation preference and participation right secure a small upside for the VCs. However, this simultaneously puts founders, employees and early investors in a financially worse position than before the investment. Notice that the VC receives a disproportionate amount back compared to their ownership percentage. Also, the options granted to employees have the same ownership percentage as convertible note holders, yet receives under half the payout. This is because the options have to be exercised first, which means the employees have to pay the strike price before getting actual shares. In this case, for reasons of simplicity, the exercise price is set to £17.50 and corresponds to the seed investment.

Before the Series A investment, shareholders only had to share the £20 million exit proceeds among founders, seed investors, and employees. Now, because the company has not increased the value beyond the £35 million post-money valuations, the VCs take out the first £15 million corresponding to their investment, and participate in the remaining £20 million on equal terms with other shareholders. This has happened in reality to many companies and is one of the reasons why founders are often hesitant towards liquidation preferences. Nobody is happy about this outcome - founders, employees, and early stage investors are disappointed that the cash value has dropped significantly since the last funding round. The VCs are also unhappy, as they have invested in a low growth company, spent considerable time on it, and possibly lost out on other opportunities.

Best Case Scenario

Exit: £0 - £350,000,000
Shareholder Ordinary Preference A % Ownership Monies out
Founders 200,000 - 38% £128,975,574
Seed Investor 57,142 - 11% £36,676,784
Employees vested options 20,000 - 4% £12,547,557
Option Pool 8,571 - 2% £0
Convertible note 21,000 - 4% £19,260,567
Series A - 214,285 41% £152,539,517
Total 520,998 - 100% £350,000,000

In a best case scenario, the company meets the VC metrics and exits at 10x the last valuation. Everybody wins. The VC still takes out the first £15 million, but it's negligible compared to the windfall that comes for everyone else too.

In the simple scenarios presented here, the takeaway should be: liquidation preferences are a downside protection for VCs, that gives them the first right to the capital paid out of the company. Founders should be aware that the liquidation preference will seriously hurt their pay-out if things do not work out as planned. But, if things do work out, everyone can reap significant benefits.

Further reading on liquidation preferences:

Series B-G

You have probably heard about unicorns, meaning startups with a valuation of more than $1 billion. At first these were few, but now they've increased in number significantly and several have become decacorns - companies with a valuation of more than $10 billion.

In recent years, it has become increasingly normal for companies to avoid IPO's and stay in the private market longer. There are many reasons for this, but it's clear that high regulation of listed companies and a robust private equity market are contributing factors. Companies simply do not have to go through the hassle of public scrutiny to receive large investments anymore. The result is the occurrence of Series B-G funding rounds.

As an example, Uber is one of the companies that have operated in the private market until a Series G round, which they secured in 2016 with Saudi Arabia's Public Investment Fund as lead investor. Even later, in 2017 they secured a $10B Softbank investment, but without a Series label on it.

Just as the term Series A was used for the first time a company issued preferred shares, the subsequent series is similarly tagged with a letter to indicate new categories of preferred shares with the later rounds having seniority over the previous rounds. This means that new liquidation preferences can have preference over a previously issued preference. In other words, if a Series B preference share has liquidity preference, its holders will receive their money first, then the Series A investors, and finally ordinary shareholders.

Further reading on funding rounds:

Startups.com have written extensively on this topic

6. The Exit

This is the dream scenario for a large number of startup entrepreneurs, as well as what receives the majority of press coverage in the field. The exit is the point at which all shareholders - founders, investors, and employees - can sell their shares to materialise their gains (or losses). For venture-backed startups, there are two ways an exit can happen: M&A or IPO.

M&A

This is by far the most frequent way for startups to exit. CB Insights estimated that 97% of startup exits in 2016 where though M&A. Also, 44% of startups exits are companies that have not made it past their Series A.

When a company is sold as part of an M&A transaction it is usually bought by a corporate, meaning a bigger industry player or competitor. Mark Suster, managing partner at Upfront Ventures has listed a number of reasons why a corporate would buy a startup:

  • Talent hire ($1 million/developer as a rule of thumb —  location matters)
  • Product gap
  • Revenue driver
  • Strategic threat (avoid or delay disruption)
  • Defensive move (can't afford a competitor to own it)

M&A transactions can be done with cash, stock of the acquiring company, or a combination of both. Investors will typically be bought out at this stage, but the founders' journey often continues even after the exit. At times, the founders and key employees will be part of the deal, having to agree to a lock-up period with the acquirer in which they will continue working for the company for a specific duration of time. This is put in place from the acquirers' side, to ensure a smooth integration of the companies and that the acquired team will continue to bring value after the transaction.

IPO

IPO stands for ‘Initial Public Offering', and refers to the first time the company will offer shares to the public by listing on a stock exchange. A company can IPO as part of a funding strategy and seek to raise capital this way. Companies such as Tesla, Facebook and Uber all raised money when listing on the exchange. Others, like Spotify, listed on the stock exchange as a direct listing without raising any money, but with liquidity for shareholders being their sole motivation. This is an unconventional method, but Spotify might have started a trend that other tech companies will follow.

As we saw in the stats from CB Insights, only 3% of exits happen this way and the number of IPOs has declined steadily for the last 30 years. So chances are slim that a company will make it here and choose IPO.

For the venture backed companies that do chose an IPO, there are several things to consider in preparation for the event. First, the valuation game: how can the company achieve a high, yet reasonable, listing price? An interesting example of this has been Uber versus Lyft, both set to IPO in 2019 with comparable business models. The first to IPO could set a market expectation for the second listing. It's basically the company fighting to keep the expectations high and then meet the markets expectations to secure the share price.

Second, founders and existing shareholders have to consider a lock-up period (typically six months) where they are not allowed to sell their shares. During this time they'll be at the mercy of the market and can only spectate as the share price is going up and down. Often, if the company fails to deliver on expectations the first two quarters, pre-IPO shareholders will have seen their price go-down.

Thirdly, but most importantly: publicly listed companies are subject to public and regulatory scrutiny. They have to publish earnings and share their expectations on the development of the business with investors as well as competitors. As a result, the administrative burden of choosing the IPO route becomes huge on any company. This is arguably the single reason why many companies chose to stay private for longer.

For a more detailed account of what to consider when doing an IPO, you can get a legal perspective from international law firm Fladgate LLP, experts in assisting companies in raising new equity, by reading the three-part guide they wrote for Capdesk readers.

A Likely (and Simplified) Exit Scenario

The spirits are high in the company following its impressive Series A round. The round has spun off a lot of positive press. The improved recognition has helped the company acquire more customers and attract employees. All things are pointing in the right direction and the whispers around the water cooler have started throwing around guesses about when the company will reach unicorn status.

As the company continues to grow, corporations are starting to notice customers using the new company's services. After a while, the CEO hears about a corporation following the company and he arranges a meeting to find out what their interest is.

During the meeting, it becomes clear that the corporation has been looking at the company's market for a while, acknowledging that the service would be a good value addition to its existing offerings, but deeming the opportunity too small to act on. They explain that they are impressed with the company's approach to the market and achievements so far, that they are not ready to act on an acquisition at this moment, but could be interested in a future investment round.

Walking away from the meeting, the CEO maintains the impression that the corporate has intentions of buying despite talking down their interest. After discussions with the board and management team, the team decides to act on the corporate interest by approaching other potential bidders - the corporates competitors.

With this move, the company is following Mark Suster's advice we discussed in the M&A chapter, and assumes a defensive stance rather than positioning itself as a revenue driver. The leveraging power of this move lies in the fact that it is more expensive for a corporate to lose market share to a competitor than gaining a revenue from a startup in an immature market.

In the end, there are two potential buyers left and the company is now trying to get the highest price and the best terms on the deal. Many entrepreneurs have sold to a corporate only to see their work buried in bureaucracy, dismantled and shut down. The negotiations in this phase can give the founders and employees a better position in the new company after the acquisition. As the bidders tire out and conclude their bidding, the company evaluates the offers.

The best offer is made by the initially interested corporate, offering £175 million for the company, and requiring the founders to vest their shares for 4 years after the exit to secure the transition and integration of services. The vesting is conditioned on the company achieving high revenue targets and bringing the product to a new market. Founders believe the plans are viable, but also know that they'll will be challenging to achieve. During the negotiation, founders get through that they will be paid 20% of the exit fee upfront, and vest the remaining sum later on.

Let's see how funds are paid out to shareholders:

Shareholder Ordinary Preference A % Ownership Monies out
Founders 200,000 - 38% £12,198,757
Seed Investor 57,142 - 11% £36,676,784
Convertible note 21,000 - 4% £9,108,507
Series A - 214,285 41% £80,043,736
Employees 27,500 - 6% £7,509,170
Total 520,998 - 100% £175,000,000

Most noticeable in the exit scenario is the founders slim pay-out of £12 million compared to the investors pay-out due to the lockup provision. There is still £48,795,027 for the founders to earn, but the founders struggle is not over until the company has successfully integrated with the acquirer. Agreements like this can take several different forms, but is typically based on milestones, period of time or a combination.

The pay-out to employees in this example is calculated on two exercise values 20,000 options at £17.5 and 7,500 options at £70.33. In other words, the employees will receive a payout calculated on the basis of value of outstanding options - exercise value: (27,500 x £335.89) - (£17.5 x 20,000 + 7,500 x £70.33). As we've shown in earlier examples, the exercise price reduce the actual payout to employees.

The option pool shuffle. Remember the Seed Investor receiving 7,142 shares more due to his understanding of the option pool shuffle? At exit those shares are worth £2.4M. What in the beginning seemed to be a negligible ownership percentage ended up as a lot of money.

Finally the Series A VC is taking the largest payout of all shareholders. They hold the most shares and have liquidation preferences. Adding more categories of preferred shares in a company will severely skew the payouts for existing shareholders. Companies should be aware of this when raising funds and run scenarios for how the investments will affect payout at different exits.

7. Summary

In our discussion above, we introduced terms and concepts related to companies cap tables and how decisions made early on in a company's life will affect its shareholders later on. We covered some essential subjects, such as how instruments such as convertible notes will affect your cap table, what liquidation preferences mean for exit proceeds, and how a company can take advantage of options or warrants to accelerate its growth.

The company example we used is a simplification of how companies organise their cap tables. As we saw, managing a company's equity capital However, the real business world is complex and equity registers in fast growing companies are constantly changing. Options are issued on a continuous basis as employees keep joining the company, and lapse when they leave again. It is often when these changes occur that companies lose track of their registers, and why it can be a good idea to switch from a cap table spreadsheet to an online cap table.

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