A capitalization table, or cap table for short, is excellent for businesses to track investors and equity ownership, employee stock option plans, displaying the percentage of ownership of various shareholders, and more. While cap tables are extremely useful for businesses, they can also become overly complicated, especially for larger organizations. A cap table that is done professionally with information that is clearly defined is vitally important. However, cap tables may require restructuring, whether it’s become too messy or diluted over time, or the restructuring has been requested by a venture capitalist. But, what exactly is cap table restructuring and how do you ensure it’s done correctly? The process is something that can definitely be done on your own but becomes less overwhelming when you work with professional cap table management software.
Cap Table Restructuring, Defined
When a cap table is broken, it’s essentially showing that those shareholders that bring the most value to a company hold a much smaller investment than those who don’t. The deterioration stems from shareholders that pursue their own goals rather than the good of the company, or from those who just don’t do anything at all.
Large companies with a higher number of shareholders will typically include a variety of share classes, including ordinary shares, preferred shares, and more. Add in debt instruments and employee incentives or options and the cap table continues to become more complicated. Recording all of this data along with other initial investment problems with shareholders can easily lead to cap table mistakes that would require restructuring.
If the equity ownership records are mishandled, the information becomes disorganized and overly complicated, you realize you’ve given away too many equity stakes or any other number of issues that may happen with a capitalization table, it’s essential to restructure.
Cap table restructuring will help organize the information for better presentation to potential new investors, rebalance control of the company, and better track the value of each share class.
How to Know You Need Cap Table Restructuring
There are a variety of cap table issues that may show up indicating it’s time to restructure. These problems and mistakes are the most common for companies that have decided to use a spreadsheet for their capitalization table as opposed to professional cap table management software.
- No or minimal comprehension of liquidation preferences by the company’s founders. Spreadsheets are great for tracking certain kinds data, but liquidation preferences are complex, and spreadsheets just don’t do a great job of showcasing that information. Cap tables are supposed to allow a company’s founders to control dilution. However, when founders don’t comprehend these preferences, it can negatively impact the dilution of shareholders, particularly upon exiting the company. Bottom line: if the liquidation preferences are difficult to follow within the cap table, it’s time to restructure.
- The option expense is unaccounted for when updating the cap table. Expenses surrounding option grants are recorded in the company balance sheet and are often overlooked. New share options require expense consideration and old awards need to be altered per guidelines set by ASC 718 for compliance with option expensing.
- Not including defensible fair market value when issuing options. This is particularly necessary for company owners that issue shares to employees. A defensible fair market value, or 409A, is essential to share price as it sets the fair market value of your company. Granting shares without proper 409A valuation can leave your company at risk for IRS audit, and you may have to pay a large amount of tax that will put your employees at risk. The accurate value should be part of what is tracked in your capitalization table to ensure 409A compliance before granting new shares.
- Forgetting form 3921 and Rule 701 if you own a larger corporation. Although Rule 701 should be common knowledge for larger corporations, some companies are unaware of this requirement. Essentially, the dollar value of Rule 701 shares needs to be less than $1,000,000, or the quantity of Rule 701 shares must be less than 15% of the outstanding shares, excluding those issued under Rule 701. Without proper cap table management or knowledge of these requirements, it may be easy to pass the threshold. Surpassing the Rule 701 threshold will result in a call from the IRS and potential penalties. Form 3921 needs to be filed yearly and is used to report ISO option grant exercises.
- Moving from a spreadsheet to cap table management software but forgetting to track the last granted paper certificates. Paper certificates need to be tracked, too. When they aren’t, the same stock can be mistakenly issued again.
- Misaligned shareholder interests. This issue can come from a variety of places. Inexperienced founders may have given up too much equity ownership upfront, and when new investors come in down the road, they may see too little equity and be reluctant to invest. Dead equity or passivity may come from investors or founders who were highly involved at the start, but are no longer invested, shifting their attention to other projects and providing no value to the company. Greedy investors who ask for higher percentages can also cause issues as new investors who come in down the road may also request such high equity expectations and, as other things like equity stock option plans and C-level hires would leave little equity ownership left for the founders.
Other issues that may result in a messy cap table include paying outsourced vendors in equity early on, having too many small investors, and getting too much initial funding from friends and family that is not properly tracked as a business investment.
Simplifying and Cleaning Up a Cap Table
First and foremost, the absolute best way to simplify and clean up a cap table is by utilizing cap table software. Being able to share a professionally organized capitalization table with investors will help increase your company’s credibility while saving you time and effort in keeping track of the information. It’s also a great way to minimize or eliminate mistakes, increasing the accuracy of the information on your cap table while better handling complex investments and stock ownership.
Cleaning up a cap table requires restructuring that would have most of the equity ownership being held by active management team members, financial investors, and an employee stock option plan (ESOP) or employee stock options. If there are any shareholders that are not included in these categories, they would need to have some of their shares transferred to shareholders that are included. This cleaning and simplification needs to be done before any new investment comes in.
Moving Forward: Preventing Broken Cap Tables
Just because your cap table has been cleaned up and restructured does not mean you are immune to it happening again, especially if it is not being managed as it should. With any endeavor, prevention is key, so you should take the time to fully educate yourself on cap table management and understand how much equity you should be dispersing during an investment round. Also, be sure to expect cap table dilution in the future as it will happen. When choosing your investors, choose wisely. You’ll need to agree on an exit scenario, as well as understand the venture capitalist’s investment horizon and targeted ownership stake. Last but certainly not least, preventing a broken or messy cap table is easily done with the right cap table management software – not a manually managed spreadsheet.
Make Cap Table Restructuring and Management Simple with the Right Software
A capitalization table is an extremely important part of the growth and journey of your business. It is definitely something that should not be an afterthought, but it is a piece that can quickly become overwhelming and easy to lose control of. Cap table restructuring is often necessary with business growth, but it doesn’t always have to be painful. Restructure and manage cap tables easily with professional equity management software from Astrella. Contact us today and request a demo to see how we can help improve your company’s cap table.
