Investing in a startup: cap table

In this post I would like to focus on the capitalization table, a spreadsheet that show how much everyone owns of a company. I’ll use the cap table  from this great post written by Mark Suster: Want to Know How VC’s Calculate Valuation Differently from Founders?

Let’s describe the various sheets in the excel file:

  • Series A – No Options: we are assuming that the founder owns 1000.000 common stocks, and he is the only stock holder. An investor wants to buy $1000.000 of shares, setting the premoney valuation at $3000.000, he will get 25%, share price at $3, and a $4000.000 post money valuation. An important observation is related to the fact that the investor is buying preferred stocks with $1000.000 ant the valuation at $4000.000 includes all the stocks preferred plus common, so calculations are always done as-if-converted to common stock basis. With this new financing round new stocks are issued, so the total stock will be 1.333.333, with the founders owning 75%:

  • Series A – Options Pre $: in all deals the investor will ask to the founder to create a pool for options to be distributed to key employees. This pool will dilute the founders stocks. If we decide to create 250.000 options, the pre money stock price will be $2.4 due to the option pool, so the true premoney valuation will be $2.4000.000. After the investment the founder will be diluted 40%, 15% due to the options pool, and 25% due to the new investment:
  • Series B: at every new round the option pool is increased, in the example, 161.000 options are added. Investor2 adds $4000.000, setting a pre-money valuation of $10.000.000,  he will get 26,7%,  share price at $5.47, and a $15.000.000 post money valuation. In this case also investor1 will increase his position to avoid dilution, so he will add $1000.000 to reach a 21,9%. If he was not investing he would be diluted to 16,3%. Is important to highlight the focus of the investor: 1) price per share, 2) true pre-money valuation, quite different from the value described in the term sheet often known as “nominal” pre-money valuation:

  • Returns-Series B 1x Preference: the second most important economic term in the term sheet other than stock price, is the liquidation preference. This term states how the proceeds from a sale or dissolution of the company will be distributed.  The idea behind this term is to protect the downside situations, but in aggressive term sheet, this term is used to take money also from an up round. This are the cases of 2X or 3X liquidation preferences with participation. To limit this effect is recommended to have a “participation with a cap”. In general the good partnerships will have 1X liquidation preference with no participation. Is important to note 2 facts: 1) the term will have effects in the following rounds, 2) liquidations have interest calculated on top of them. The following example describes 2 exits: 1) up round at $100.000.000, and 2) down round at $12.000.000 (note: down only for series B investor). In case 1, all the stock holders have a nice return, in particular the series A investors will have a 15X return:

In the case 2, the situation is much different and the series B investor will get back his money exercising his preference rights, the series A will make some return, and the founder and the employees will get what is left:

  • Returns-Series B Participation: In this case the investor receives preference and participates in common, effectively “double dipping”. In a big exit, participation doesn’t matter as much, but the smaller the exit, the more effect participation has:

There are other important terms that define the stock architecture of the company after an exit. This are well described in the Brad Feld term sheet series:

In addition there are legal binding terms like exclusivity (normally 6 weeks) and confidentiality, right to a board seat, etc… For more information you can check the NVCA term sheet (used by Mark Suster for some deals),  Y Combinator, Techstars, Venture hacks, Felds term sheet series, Fred Wilson, and Chris Dixon blogs.

Now that we understand the VC language, we can start creating a list of recommended layers like the Gunderson suggested by Chris Dixon or Wilson Sonsini Goodrich & Rosati (the known layer firm that has collaborated with Y Combinator for the Series AA Equity Financing Documents), to be prepared when a favourable opportunity will arise. Understanding the language is the first step to communicate with a VC, the next step is to create a trusted partnership where both sides of the deal will be capable to generate value for the customers, and then retain and share part of it.

Any recommendation related to term sheet negotiations? Any hint from VCs, or layers you meet during your startup experience?

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