Entrepreneurs are often confused and sometimes even frightened when an investor asks to see the “cap table” or capitalization table. If an entrepreneur doesn’t have a capitalization table then there is great deal of fear to be had and it’s not because the investor is asking for this document. It’s because the entrepreneur has not done a very good job in structuring the financial building blocks of the company namely the number and price of shares that make up the “capitalization” or valuation of the company.
- (Click to download the YCE Capitalization Table product. It’s FREE)
A capitalization table is an important document because it shows who owns the company and what they paid to obtain the shares for this ownership. If you are accepting money from investors you must have this document as it shows two important elements that:
- You have done the proper paperwork in documenting ALL of the shares offered by the company.
- You have established a valuation (price) of each share at each subsequent round and can provide a rationale for the share price being established resulting in an overall company valuation
A capitalization table is important because if it is not kept up to date and investors that you have accepted money from are not on the list – law suits can fly. Worse yet, if a new investor finds out that there are investors that are unaccounted for and not on the list, it is a sure fire fact you’ll never see a dime from that investor. Trust being an important factor in any transaction.
Principles of Capitalization Tables. Tell the Investor a Story
A good capitalization table should be guided by the following essential principles.
- It should do more than just list the names of all the shareholders and their respective share ownership numbers and percentages. It should tell an investment story by chronicling appreciated value of the company over time.
- It will show what type of investor came in at each round and the associated share price paid by these investors at a point in time and is used as a forward looking tool to see the impact financing decisions on ownership, dilution and capitalization values of the company over time.
- It should be the cornerstone in making sure all the paperwork is properly registered, filed and distributed when money is exchanged for equity. For example, paper work needed by the Securities Commission to be filled out by the investor, promises made to others via verbal agreements are then fulfilled and logged in a paper trail with the issuance of share certificates (make sure your lawyer controls these).
- It should be used as an important tool in the establishment of a fair valuation for the company by rationalizing deal arithmetic into a clear and concise document.
I will be covering more about capitalization tables in the weeks ahead to help entrepreneurs understand the components of a good cap table, how to use them, and how deals are structured with them.
Valuation can be a black art even when you’ve got revenues and a record of expenditure you can use to calculate projected profits over a number of years. After all, who is to say that those profits will stay constant? What if a competitor comes out with a product that’s going to give your company a run for its money?
How to Value a Company. Use the Tools and Avoid Common Mistakes
Valuation can be very subjective. And again, if you’re dealing with a startup, there are so many variables it can be tough for an entrepreneur or investor to know where to begin.
- (Download our simulation tool that helps companies establish valuation estimates as guidelines for discussion with investors)
Here are some common mistakes even self-styled experts have made that you want to avoid:
- Lack of objectivity. A company executive may be tempted to post an overly optimistic business forecast. Skittish investors who don’t have all of the information may be too pessimistic. You need balance.
- Forget about cash flow. It is tempting to look at the overall revenue minus expenditures and call it a day. But what happens when a company faces monthly bills and only manages to get paid by its customers every 3 to 6 months? Once the startup cash burns out, a problem with cash flow can put the kibosh on a business – which won’t do wonders for its valuation.
- Counting intangibles. Customer goodwill, great branding and a convenient location are already accounted for in the company’s sales (eg. When Apple sells an iPad, its sale is a result of its brand recognition and easy-to-find stores). So you don’t need to count these things twice.
- Comparing apples and oranges. “Industry average” revenues or expenditures may not apply to a single niche company touting an innovative business model or blockbuster product.