Private Placement Tutorial: How a Capitalization Table Works
As Finance Friday continues, companies are finally introducing the idea of the Cap Table to their executive management teams. This week they finally establish their cap table and employ a CFO. Equity is divided equally and evenly, but where does that technically get billed?
Well it appears that all equity compensation package information is now considered full disclosure. If you think about what makes up the cap table, you probably already know that the basic components are the CEO's salary, the non-custodial owner's stock, and any bonuses the company awards its team members. The key is to make sure that this information is up-to-date at all times. Why is this important? Read on...
One of the main reasons for creating cap tables is to ensure that company announcements (especially negative ones) have the least possible amount of impact on quarterly profits. For example, Microsoft released news last February that they are reducing their workforce by up to 500 employees as they work to "reduce employee costs". Naturally investors were concerned about this announcement since the company typically reports three quarters in a year. When the quarterly profits do come in, the reduction in workforce should not have a major impact since the company's gross profit will still be high. However, with the cap table spreadsheet, investors can better understand the financial results so that they can properly assess this situation.
The other reason why it's so important to have cap tables is to protect the equity holders. Since the company announces these reductions, they must then provide notice to all of their stakeholders. If startup are shareholders, then it is likely that they will hold onto their shares and invest in the company. If the workers lose their jobs, then they have to find a new job or pay the cost of a new unemployment insurance claim until the company adds back the workforce. With cap tables, investors and the employees can easily enter their trades accordingly.
It's also smart for corporate management to issue a formal announcement of any reductions through cap tables. Investors can then react accordingly. If the number of shares owned is low, then the equity may dip but the overall value will not. Investors can buy up shares of the company if the overall value is still very attractive, especially if the price is below book value.
The importance of these cap tables cannot be overstated. Private equity managers often operate with no cap table because they don't need one to make a reliable forecast. Instead, they just know that the overall profit will come in during the first few years, and then they can safely invest for the future. However, this isn't always the case. If a company is expanding quickly, or has just received financing from a third party, then a cap table is crucial to accurately predicting its EPS growth, as well as its potential return on equity.
As mentioned earlier, there are three different types of cap tables: simple cap tables, inflation-adjusted cap tables, and negative-leverage and fair value-based cap tables. A simple cap table is one that only gives an estimate of EPS before taxes; it doesn't factor in the effect of dividends or capital gains, and doesn't include non-recurring charges such as stock options. Inflation-adjustable cap tables allow investors to more accurately predict the long-term value of equity since the prices are updated for the same index every year. Fair value-based cap tables use a variety of different metrics to determine the value of a particular stock based on historical data, rather than current price data.
When startup 're an angel investor looking to participate in a private placement, you should ask the managing partner how he or she plans to adjust funding levels if growth expectations or financial performance change significantly. In most cases, the answer will be in terms of a cap-table. A cap-table is a spreadsheet that helps investors calculate the potential return on investment by applying expected growth to current and ongoing cash flows. The purpose of a cap-table is to help potential funders assess which types of transactions are best designed to generate the greatest long-term benefit.