Founder Series: Getting to Grips with the Cap Table

8 minute read | January.25.2024

Orrick's Founder Series offers monthly top tips for UK startups on key considerations at each stage of their lifecycle, from incorporating a company through to possible exit strategies. The Series is written by members of our market-leading London Technology Companies Group (TCG), with contributions from other practice members. Our Band 1 ranked London TCG team closed over 200 growth financings and tech M&A deals totalling $2.86bn in 2023 and has dominated the European venture capital tech market for 31 consecutive quarters (PitchBook, Q3 2023). View previous series instalments here.

We have seen it far too many times. The business is excellent, the pitch deck is polished, the team are prepared and the investors are interested. Yet when discussions progress to details of an investment and related terms, the company is unsure who its shareholders are, unable to produce a cap table when requested, and unaware of the financing impact on shareholding percentages -or a worrying combination of all of the above.

Investors want to have confidence that a company’s records are in order, particularly when it comes to the share capital, and that it is on top of the details. That is why it is essential for founders to have an updated and accurate capitalisation) table.

As noted in our Get Ready to Raise instalment, your cap table provides a comprehensive overview of the company’s share capital. At a basic level, it sets out the shareholders and the number of shares they hold. However, to really add value a cap table should go deeper in its detail and analysis.

In the eighteenth instalment of Orrick's Founder Series, we will discuss what you need to know and what to do to get the most out of your cap table.

1. Know your shareholders (KYC). The cap table should contain the full legal name of each shareholder. This is important as the cap table is often used as the basis for preparing legal documents, including subscription and shareholder documents, or carrying out Know Your Customer (KYC) checks as part of ongoing compliance requirements. Ensuring accurate details from the start will help avoid administrative delays down the line.

2. Know your shareholders (company registers). The cap table should also match the company’s register of members. While the cap table and register of members both record shareholding, they serve different purposes. The cap table is useful for showing percentage shareholdings relative to other shareholders or for calculating voting thresholds, but it is an internal document without legal significance – whereas the register of members is a statutory obligation required under the Companies Act 2006. However, as they are both used as significant reference points, they should be consistent with one another. Please see our first instalment, Setting Up Your Private Limited Company, for tips on keeping your company records clean.

3. Existing Option Pool (allocated vs. unallocated). As part of setting out the current capitalisation, it is important to have a clear understanding of any shares reserved for a share option pool.

If you are raising your first round, you may not have formally reserved shares for an option pool. This is standard. We usually recommend that early stage companies defer implementing a formal share option pool until they raise the first round of institutional financing.

However, if you have created an option pool, the cap table should set out the number of shares reserved for the pool and the split between how many shares have been allocated and how many shares remain unallocated and available to the company.

4. Option pool top-ups. Investors usually want to see a certain size of option pool available following the investment so the company can fulfil its hiring plans for the next 12-18 months post-close.

If the company does not have a sufficient unallocated option pool available, investors will likely include a top-up to the option pool as a fundamental deal term. Any top-up is usually included in the pre-money valuation, meaning it is dilutive on existing shareholders and not new investors. As such, it is an important data point in calculating the round price and dilutive effect of any proposed financing.

5. Subscription calculations – rounding pitfalls. Save where you are setting out the company's current capitalisation (which can be hard-coded), most other numbers in the cap table should be derived using formulas. A common error in cap tables, particularly when using formulas to calculate numbers, is the absence or misuse of rounding.

It is not possible to have fractional shares in a company so all shares must be calculated as whole numbers. As such, when calculating share numbers, companies should use a ROUNDDOWN formula to ensure no fractional entitlements exist.

Relatedly, all shares must be fully paid up to be validly issued. As such, when calculating subscription amounts, a company should use a ROUNDUP formula to ensure it receives the full payment amount.

6. Convertible securities (general). The company may have issued convertible securities (e.g. loan notes, advance subscriptions, SAFEs, warrants, etc.) that remain outstanding, often until a conversion event occurs.

It may not therefore be possible to determine the exact number of shares that would result from the conversion of a convertible security at the time that it is issued (e.g. if the price is not determinable until the type of conversion event and parameters of such event become certain). However, keeping a good record of them will allow the company to track and deal with those securities as and when needed.

7. Convertible Loan Notes. A convertible loan note is a common security companies issue in bridge financings. They are popular in uncertain markets as they defer the question of valuation and priced rounds (see more on bridge financings in tenth instalment, Raising Bridge Financing).

The conversion terms usually provide for automatic conversion on the next equity financing at a certain threshold. If this is triggered, the cap table should include the conversion calculations and reflect the resulting shares in the post-completion cap table.

8. Warrants. Warrants are a slightly different security. They provide a right for the holder to acquire shares at a certain point in time and/or at a certain price. Warrants may or may not be exercised in a financing round, but it may be important to include them in a cap table as they can have a material impact on the fully diluted share capital (and therefore any option pool considerations).

9. Pro rata pre-emption rights. The company's articles of association will likely include provisions which give existing shareholders a pro rata right of pre-emption (i.e. a right of first refusal) on any future issue of shares.

Although pre-emption rights will normally be formally waived as part of a financing round (to avoid the cumbersome and time-consuming pre-emption process), companies will often reach out to their existing shareholders on an informal basis to enquire whether they are interested in taking up their pro rata entitlements.

It can therefore often be helpful to include the pro rata calculations (based on the current percentage hold of each shareholder) within the cap table, to provide a basis for these discussions.

10. Post close positions. The greatest advantage of a detailed and accurate cap table comes in the insights it can provide when negotiating key deal terms, such as voting groups or shareholding thresholds for certain rights such as information, consent matters or board appointments.

The current capitalisation is combined with details of any option pool top-up, the new investors and subscription calculations and the conversion of any convertible securities, to present a pro forma cap table setting out the shareholders after a proposed financing. This should include calculations of the number of shares held on an issued (i.e. voting) and fully diluted (i.e. including all options, warrants, convertibles, etc.) basis.

This post-close cap table will provide reference and insight into how certain deal terms can be negotiated and set. Founders may be able to determine the dilutive impact of the round and foresee if they will fall below any significant voting hurdles (e.g. 25% or 50% of issued shares). It will also show investor shareholding. That can be used to set an appropriate threshold for receipt of certain information rights, control any consent rights, or the ability to appoint a director or observer to the board – which may be set to encourage follow-on investments or participation in future fundraising.

As these key terms are usually negotiated and agreed at the term sheet stage, it is incredibly helpful to have a pro forma cap table from the start so these and other issues can be highlighted and dealt with up front. This avoids issues and conflicts later, leading to a more efficient transaction for all parties.

Our London TCG practice reflects London’s role as one of the world’s leading financial markets and a centre for international commerce. Nothing inspires us more than helping tech companies develop novel strategies and push boundaries. Through our extensive client portfolio, deal volume, and relationships in the tech ecosystem, we provide commercial and legal insight to each company’s strategy. We work with tech companies on all aspects of their business plans: financing strategies, protecting intellectual assets, retaining talent, securing and monetising data, and advocating for innovation-friendly public policy.

If you would like more details on any of the issues above, please contact Jamie Moore and Stephen Tallon.