As the document that tracks the ownership structure of your company, your cap table (or capitalization table) should display the full list of individuals, institutions and other entities that have an ownership stake in your company. Yet, while it sounds simple in theory, maintaining accurate records regarding each shareholder’s security holdings has the potential to become quite complex. To help you avoid some common pitfalls, here are a few cap table management tips to consider.
1. Understand Option Pricing
When founders first begin to issue equity in a company, they often choose to grant options. One of the challenges of these grants for private companies is setting a fair price for the options.
Under the US Internal Revenue Code (IRC), incentive stock options (ISOs) must be granted with a strike price equal to or greater than the fair market value of common stock.1 Granting options too low could result in tax penalties for employees, excess costs incurred by the company and holdups during an acquisition or IPO. Conversely, if you grant options too high, employees may miss out on value they may have otherwise received.
To set a proper option value for cap table management purposes, private companies may want to consider obtaining annual 409A valuations from a reputable valuation provider. By determining the fair market value of your common stock, a 409A valuation helps set the strike price for your option grants and may prevent your cap table values from being called into question.
2. Understand the Regulatory Environment
To make sure the information on your cap table remains accurate and verifiable, you may need to comply with various different regulations. These may include:
- ISO $100,000 limits, which stipulate how many options can vest in a given calendar year to qualify for certain tax treatment.2
- IRC 409A regulations, which require some companies to conduct a formal valuation at least once a year to determine an appropriate strike price for options.2
- ASC 718, which is an accounting requirement for measuring and recording the expense associated with issuing equity-based compensation.2
- Rule 701, which exempts some companies from registering with the Securities and Exchange Commission (SEC) before issuing equity-based compensation.3
- 83(b) elections, which may allow certain employees to file an election within 30 days of receiving restricted stock awards (RSAs) to obtain preferential tax treatment on the sale of their equity.2
To understand which regulations apply to you, consider consulting with a legal advisor.
3. Learn How to Analyze the Impact of a Financing Round
When a company raises a new round of financing, it will generally issue a new round of equity-based awards, such as preferred stock or convertible debt.
Preferred stock awards may have terms that govern an investor’s liquidation preferences, participation rights and participation caps. Similarly, convertible notes (such as KISS notes and SAFE notes) may include provisions outlining conversion caps, conversion discounts and warrant coverage. These provisions can sometimes mask how much dilution may result from the conversion.
To understand how a potential financing round will affect the cap table, it is important to model different scenarios and combinations of terms. Without this analysis, you may unknowingly give up more value in the company than intended.