“Most businesses do not understand the cap table concept in the early stages of their operations,” says Jon Miller, president of CapTables, an international tax consulting firm. “When they start looking at potential funding sources, they already have an idea of what they need to qualify for a corporate loan. If a business needs a small amount of money to get started, it makes more sense to apply for a business loan than for a line of credit or an equity loan, because the business’s business plan does not yet sufficiently address funding needs.” However, when a business becomes more mature and needs more financing for growth, it is usually necessary to obtain one of several types of financing through a bank, private investor or a venture capital firm. The key issue is how to properly structure these relationships to enable the financing to be obtained.
“One of the permanent laws of venture capital investing is that there are simply 100 available spots on the cap table for new businesses.” Each business has a pre-money position on its cap table, which represents the maximum amount of money that it can raise. On the surface, a cap table represents a simple set of mathematical equations. The rate at which early-stage companies raise money, the amount they can raise and the risk they face in raising capital are all part of this equation. In reality, however, it is much more complex. While early-stage companies have an advantage in being able to rely on a relatively small amount of capital, potential funding rounds can quickly deplete a business’ capital cushion.
Most entrepreneurs try to access capital through a traditional bank rather than an investment firm. Because startups offer higher interest rates on loans, they provide companies with a greater incentive to use their credit facilities. Unfortunately, this presents a significant problem for savvy entrepreneurs: Many savvy entrepreneurs view capital gains as a means to achieve higher ownership percentages. Capital from an investment firm has two goals: one, to earn higher dividends and two, to obtain a higher net return on company ownerships.
By following pre-money procedures and assuming the highest percentage ownership scenario, most angel investors will invest directly into a company’s line of credit, using the funds as they arise. As capital requirements are satisfied, company owners begin reaping the benefits of their ownership stake as the company makes progress toward growth and profits. However, the ideal scenario for capitalization tables – where the company meets all pre-money requirements – rarely happens.
As mentioned above, pre-money requirements represent the most significant factor in determining the optimal level of ownership percentages. This represents a major shortcoming of most cap table math analyses. Most commonly, investors calculate the value of shares based on a hypothetical 100% dividend scenario. By only considering the assumption of a perfectly distributed income (i.e., no annual or quarterly dividend), the true value of shares is vastly underestimated. As a result, many companies fail to realize significant growth potential by focusing only on the dividend rate – which typically locks investors into their seats by paying high dividend yields with limited liquidity.
A second major shortcoming of cap table math is the use of convertible notes and debentures as part of the calculation process. The convertible notes and debentures typically carry much lower conversion rates compared to common stock due to their intrinsically less valuable nature. This means that an investment firm may underestimate the value of its convertible notes or debentures when using pre-money valuation techniques. startups holds true for all types of debt instruments (e.g., commercial real estate loans and general obligation securities).
Most entrepreneurs are well-versed in cap table management. The truth is that entrepreneurs who are successful in their businesses know how to manage these financial assets – which often leads them to underestimate the value of their business’s equity. The founders of a company are often attracted to the company’s management team because of their knowledge and experience. Unfortunately, they may not be aware that the management team is relying on inadequate information or fail to properly align with the company’s founders to arrive at a robust and appropriate valuation of the business’s equity.
As a result, they could underestimate the value of their shares, which would inevitably lead to over valuation and a costly realization of losses. The best way to avoid this problem is to engage the services of a professional Cap Table Management Service. These firms not only assist entrepreneurs with the fundamental calculations needed to properly assess their businesses’ shares, they also provide entrepreneurs with options to successfully fund their businesses. As most investors will agree, capitalizing on options is a much more affordable alternative than over-pricing your shares in the open market.