Many doctors in our physician communities are either looking to start companies or join startups either as co-founders, investors, or startup advisors. Each of these roles is very different, but one similarity that they often share is that you usually get some form of equity in the company as a part of (or potentially all of) your compensation for the work that you do in building that company. It’s very important to understand the capitalization (cap) table when you are entertaining an opportunity, so that you can understand exactly what your ownership is, how that ownership may be diluted, and what you can expect as the company’s valuation (hopefully) continues to grow. Below, we’ll cover the basics of the cap table of a startup or early stage company.
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What is the capitalization (cap) table?
The capitalization (cap) table breaks down all the people who hold equity ownership in a company. While we mostly hear about it in the context of startups and early stage companies, all companies can have one.
The cap table can vary in complexity, but it will essentially list every shareholder, the type of shares that they own, the ownership stake each shareholder has or may have in the future, the value of those shares, how and when the shares can be exercised and how much each person will pay for those shares if and when a liquidity event such as a sale or IPO happens. It also shows you the current market value, how many shares have been issued, and how many have not yet been issued.
While this may sound simple, the cap table includes common equity shares, preferred equity shares, warrants, and convertible notes. As a company grows, the different types of shares add complexity, as each type of share has different rules attached to them. It will also track things like an option pool size, outstanding shares, and SAFE notes, which all come together to provide a complete picture of ownership or potential ownership.
The cap table will evolve as the company adds investors or raises capital or goes public via an IPO. You may have heard of startups raising angel rounds and then various series rounds (series A, series B, series C, etc.). Each time that the company closes another round, the cap table is redone to reflect new owners, and the previous ownership will be diluted.
Without getting into too much detail, hopefully you can see that company ownership can get complicated very quickly.
Why is the capitalization (cap) table so important?
As the company grows, there needs to be transparency in who owns what percentage of the company. This will factor into many key decisions when deciding how much capital to raise, what the price of each share will be during each fundraising round, who has decision making power, and how everyone’s ownership will be diluted if new investors come on board. Potential investors, employees, or advisors will want to know information about it before deciding whether they want to come on board.
What types of shares and stock options exist?
Generally speaking, at every cap table, there are common shares, preferred shares, and rights, which are convertible instruments which have the potential to become shares at a later date.
Shares are ownership percentages in the company that actually exist in the moment, whereas rights give you shares or the ability to buy them in the future.
Shares are divided into common shares and preferred shares. These are equity and the price is determined when they are granted.
Common shares are usually given to founders and company employees, with the founders dividing the common shares at the time the company is created. The founders will also often set aside a percentage of the shares for future employees of the company from this common share pool. Shares can be granted to employees from this pool based on the duration of their employment, etc., or be granted to the employees in the form of stock options.
Preferred shares, on the other hand, are usually owned by investors. Ironically, as the name indicates, these shares actually have priority over the common shares in payouts both at the time of sale or going public, or if a company goes bankrupt. Additionally, depending on what the term sheet specifies and how much leverage the investors have, the investors can actually ask to be paid out at multiples of what they invested before the founders and employees get the rest of the money to divide amongst themselves.
What types of rights exist?
Convertible instruments, unlike shares, don’t have a set price when they are granted, because it’s unclear what the valuation is going to be when you want to grant them. The two main types of these are the SAFE note and the convertible note.
The SAFE note has become popular in the startup world. It stands for Simple Agreement for Future Equity. It doesn’t have to be repaid with interest or at a particular maturity date, but is paid back whenever you raise money in a priced round. While there’s the least commitment with these notes, they often come with terms that ensure that they always get the best terms available or can dilute your ownership. This includes potentially including a valuation cap, which is beyond the scope of this article, but will ensure that they are not diluted too much.
The convertible note is debt that you take on that has to be paid back with a specified amount of interest. That debt is paid back in the form of shares in the company that have that value on a later date, which allows an investor to make an investment into an early stage company before it has value or is generating revenue. Once a company has an event like a fundraising round where a valuation is declared, that note can be converted into shares. There are more complexities to this, as these notes have maturation dates which are due regardless of whether or not you’ve raised a round, and there can be valuation caps and discounts, but that is beyond the scope of this article.
What are stock options, vesting schedules, and strike prices?
If you remember above, we talked about how the founders will often set aside a portion of the common stock for their employees.
This is where you often hear about stock options, which are not yet shares as they are not yet owned, but which give employees the right (but not the obligation) to buy specific amounts of shares at a particular price at a particular time. If you hear the term ESOP (Employee Stock Ownership Plan), this is often related. The important thing here is that the price of those potential shares is determined ahead of time, which is different than the rights that you saw covered above.
Now, it’s important to understand that most companies will not grant their employees shares on the day that they start with the company, as too much can go wrong. If someone quits or is fired, you don’t want them to have ownership. They have to earn that ownership, and you want to incentivize them to stick around and help grow the company.
This is where the vesting schedule comes into play, which is an agreement between the company and the employer that delineates when your shares become yours or you can exercise your option to buy a certain number of shares at a predetermined price (called the strike price or exercise price). Vesting schedules can either have a cliff or no cliff. A cliff means that they have to wait a certain amount of time, like a year, before they can get any shares, which gives the employer a chance to test a relationship before allowing the employee to have a claim to ownership. Once they hit that cliff, they typically are given shares monthly. If there is no cliff, they start getting shares immediately. The exact number of shares they get each month depends on the vesting schedule, but there will be a set period of time over which they are granted their options or shares. For example, if you have a four year vesting schedule, your shares will be granted over that time, at which point you will be “fully vested.”
Occasionally, vesting schedules can be based on hitting certain milestones instead of based on time, but those are much less common and beyond the scope of this article. Additionally, you can issue multiple different groups of shares which each have their own vesting schedules and terms.
Another thing to keep in mind is that stock options can have an expiration period which means that if the employee doesn’t exercise their options in a certain amount of time, they can go away, so checking the agreement for the details is important to make sure you don’t give away your options without realizing it. Similarly, when you leave the company, you will give away your rights to any shares that haven’t yet vested. You may also have a certain amount of time after you leave the company where you must exercise your options for any vested shares, so this is also important to prevent your shares from going back into the option pool.
How do you know the value of each share that you have at any given time (fair market value and valuations)?
If you own shares, you’re going to want to know what they’re worth. The fair market value is the value of one share. It is determined by doing a 409A valuation. This valuation is based on having an independent valuation of your company using standard valuation methodologies based on a market approach, an income approach, and an asset approach. If you’ve ever sold a private practice, you likely recognize similar terms from how to value your practice.
What is dilution, and how is it affected by raising capital?
This is a very important concept that every shareholder should understand. As stated above, at any given time, most companies have a certain number of shares that have been issued, and a certain number of shares that are unissued. Your percentage ownership in a company at any given moment is determined by dividing your shares by the number of shares that have been issued. However, when new people come into the company’s cap table, whether they are investors, employees, advisors, or consultants, their shares (unless being given from someone else’s shares) will grow the total number of shares that have been issued, thereby decreasing your percentage ownership of the company even though your number of shares hasn’t changed. That’s why you always want to ask about how many outstanding shares there are in the company, as this gives you an idea of how much you can be diluted just from those shares being issued.
Where things get really complicated, though, is when the company raises capital. When they do this, they will raise a certain amount of money that will actually create more shares within the company. The amount they raise will be divided by the price of each share (which will be based on the valuation that the company is raising at) to determine how many more shares are being created. This expands the cap table significantly, and again will dilute your total ownership in the company even though you still hold the same number of shares.
When is the cap table created?
In an ideal world, every company would know from the beginning that they were going to accept shareholders and would create the cap table simultaneously with filing the articles of organization when creating an LLC or a corporation. When you create a corporation, you declare how many shares of your company exist, and depending on the state, you may have to give those shares a value (usually people give those shares no value because the company has no value yet, but that discussion is beyond the scope of this article).
Since many people start side gigs or companies not anticipating future growth, the reality is that it’s not always done this way, but founders that know that they’re starting a startup are usually encouraged to do this from the get go. They then split the shares in whatever distribution they think is fair amongst the co-founders, as well as think about what percentage of the shares is going to go to investors, employees, and advisors.
Conclusion
Cap tables are very complicated and can get very confusing for those not familiar with the startup world. If you intend on being a physician founder of a startup, you’re going to want to do a lot more reading to understand the nuances of the cap table. If you are a physician that’s been offered shares in a startup because you’re a startup advisor or employee, hopefully you have a better understanding of your shares and important concepts like how they can be diluted.
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