Cap table – 5 Common cap table mistakes to avoid

Getting your capitalization (cap) table correct on day one and then maintaining it over time is going to be one of the top priorities for any start-up company.

Why is it so important? Before we explain the Why, let’s be clear on the What.

What is a cap table?

Put simply, a cap table is a record of the ownership of your company. It outlines who are the stockholders? What are their individual stakes? Which types of securities have been issued, e.g., shares, convertible notes, and warrants, and under what terms?

Why is it important?

The why flows naturally from the what. Having accurate and up-to-date information on your ownership and securities structure at your fingertips at all times is crucial.

The details will change through each funding round, and potential investors will closely scrutinize your cap table when evaluating your company and determining whether to enter into an agreement with you.

As a founder/owner one of your goals when seeking outside investment should be to anticipate reasons why an investor might say “No” and look to address those issues in advance. The accuracy and content of your cap table can constitute one such point. Founders should understand the importance of their cap table, both as a record of ownership and “shop window” when it comes to attracting the all-important outside investment.

Here, we outline five commonly made mistakes you should look to avoid:

1: Maintaining your cap table on a spreadsheet

Spreadsheets are useful for many tasks, but as an ongoing log of the distribution of company equity there may be better alternatives. On day one, when you have perhaps five employees, using a spreadsheet to manage your cap table might seem like a good idea, and maybe it is… when you have five employees.

The issue is that you hope your start-up is going to grow and become successful over time. So, fast forward three to five years and you might have 100 employees – at that point, it will be far more challenging to maintain an accurate record via a spreadsheet of who has how much of what type of equity and their various relevant vesting arrangements. It’s not impossible, but relentless care and attention to detail will be required, and even then the possibility of a manual data entry error having occurred will always be present. The bigger you get, the greater that admin burden becomes, and the less confident you can be that your cap table is giving you the reliable snapshot you (and potential investors) want.

The alternative to a spreadsheet is to use automated software. With a dedicated software solution, the work can not only be done faster but you basically remove the human error element, which will always exist with any method reliant on manual input.

2: No single source of truth

This is one of the main issues that can arise when relying on spreadsheets. It is not difficult to imagine how older and newer versions of the same document could end up in circulation, with no guarantee that key updates recorded in one version are mirrored in the others, and slowly but surely the integrity of your cap table can be undermined. This is not something that any prospective investor would want to see.

Again, the key take home point here is that for accuracy and peace of mind, automated cap table software can serve far better than a spreadsheet.

3: Inconsistency on entity names

When working with stock certificates, it is essential that you are consistent in how you refer to individuals and companies. Using abbreviations (e.g., shortening a company’s name with brevity in mind) or variations on names (e.g., using someone’s middle initial on some occasions but not on others) can be a recipe for confusion, with this in turn potentially leading to cancellations or having to replace mislabeled stock certificates. When it comes to names, perhaps the best advice is to stick to the formal legal version. Brevity is best… except when it’s not. This can be one such instance.

4: Not linking issued options to a valid FMV

Companies require a 409A valuation in order to set the fair market value (FMV) of individual shares. However, it is not unheard of for the founders of early-stage startups to make the error of issuing stock options either a) without a formal 409A valuation or b) outside the 409A safe harbor recognized by the IRS.

5: Failing to understand tax rules

Taxation can be complicated. When you offer options to new or current employees, you need to be clear on the different tax implications. For example, in some instances, tax may be due at sale but not at exercise, while in others tax may be due at both events. You also need to understand whether tax is paid by the employee or taken at source.

The key point here is that not all equity offerings are taxed in the same way and a failure to distinguish between different offerings could lead to unwelcome tax consequences, both for the company issuing options and those employees who received them.

Understanding the importance of your cap table means needing to know what potential pitfalls to avoid, what “red flags” may alarm potential investors, and also the basic mistakes that can undermine the integrity of that record. As we’ve seen many cap table errors can be traced back to issues related to using spreadsheets (e.g., input errors, multiple versions) and poor decision-making (e.g., not understanding tax obligations, not linking issued options to FMV). The former category can be successfully tackled using automated software, while the latter is a mainly a matter of educating yourself or speaking to those professionals experienced in the field of cap table management.

Global Shares, a JP Morgan company, is ready to assist you on both counts. Our industry-leading automated cap table management software can greatly reduce your admin burden and enhance your peace of mind as it relates to the possibility of human error, while our dedicated personnel can also offer you the benefit of their years of experience working with clients on their cap tables.