Welcome to the fascinating world of securities, shares, and other cap table elements! If the mere mention of these terms makes you scratch your head in confusion, fear not! We're here to demystify these financial concepts with a sprinkle of simplicity. Ready? Let's dive in, and at the end of this article, you can also check out some practical uses for the information provided.
A cap table is a fancy term for a list that shows who owns what in a company. Of course, you make one if you want to know easily who holds the shares and how much of the company they own. It's not only a chart that keeps track of the ownership percentages, but it also shows who has a say in the company's decisions. You may know all of this by heart, but if your company grows beyond a certain limit, you may want to use your memory for more important things.
Equity is like a slice of the company pie that represents ownership. It's the ownership stake or shares that someone holds in a company, giving them certain rights and a potential share of the company's profits. When someone has equity in a company, they are considered a shareholder or an owner of that company.
Equity is typically represented by shares (also known as stock), which represent a portion of the company's ownership. The number of shares a person holds determines their ownership percentage and gives them certain rights, such as voting rights on company matters and the potential to receive dividends or participate in the company's growth.
Investors, founders, employees, and other stakeholders can acquire equity in a company through various means, such as purchasing shares, receiving stock options, or participating in equity-based compensation plans.
Securities are in simple terms pieces of paper (or digital records) that represent ownership or debt in a company. They're official certificates that say somebody has a certain right or claim. There are two main types of securities: equity and debt.
Equity means that somebody owns a part of the company and is called a shareholder or an owner. The shareholder gets certain rights, like voting on important matters and the potential to share in the company's profits. So, think of equity owners as having a share in the success (or failure) of the company.
On the other hand, debt involves somebody – an investor - lending money to the company. In exchange, the company is promising through a signed agreement to pay the loan back with interest over time.
To summarize, equity is about owning a piece of a company and sharing in its success, while debt is more like lending money and expecting it to be paid back with interest.
We bother here with securities because a cap table contains, besides equity, also some other things we will describe below, which all belong to the generic category of securities.
You should bear in mind that securities are tradable financial assets that hold value and can be bought, sold, or transferred.
A cap table has at the minimum just equity (stock – common and/ or preferred) and shows how many shares each shareholder owns. But reality is usually more complicated. Let’s briefly describe the main types of securities you could find in a cap table:
Options are like tickets that give you the option to buy or sell shares at a certain price in the future. They're like secret passes to potential ownership.
In a cap table, you might encounter several types of options, such as employee stock options (ESOs) or stock options issued to investors or executives. These options represent the right to purchase company shares at a set price in the future, allowing individuals to potentially benefit from the company's growth and increase in share value.
In a cap table, you will most probably see the following types of stock options:
The cap table would include the details of these stock options, such as the number of options granted, the exercise price, the vesting schedule, and any expiration dates.
An option pool is a reserved stash of stock options set aside by a company. It's like a little treasure chest that's kept handy for future use. The company uses this pool of options to lure in new talent, reward employees, or entice investors with the factor of “ownership” The creation of an option pool is a widespread practice, especially in startups and high-growth companies.
The purpose of an option pool is to provide a reserve of shares that can be granted as stock options to attract and retain talent, incentivize employees, align their interests with the company's success, and facilitate future equity-based compensation. The company could thus grant stock options without requiring immediate dilution or seeking approval for additional shares. Of course, the company could decide to have a shares pool, which is more straightforward and will show up in the equity section of the cap table right away.
The option pool is an important aspect of a cap table as it represents potential future issuances of stock options that can impact ownership percentages and the overall capitalization of the company. It provides flexibility for equity-based compensation and makes sure employees and stakeholders are interested in the company's growth and success.
ESOP stands for Employee Stock Ownership Plan and is a type of employee benefit plan that allows employees to become partial owners of the company by receiving or purchasing company stock. ESOPs are typically used as a form of employee compensation. The company contributes shares of its stock to the ESOP, which are then allocated to employees based on certain criteria, such as years of service or compensation levels.
Employees get a chance to be true company owners, and the company gets a motivated and engaged team ready to give their all. It's like a huge group hug of shared success!
ESOPs offer several benefits for both employees and the company. For employees, they provide a mechanism to accumulate ownership in the company, building a sense of ownership and participating in its success. For the company, an ESOP can be a way to incentivize and retain employees, improve employee morale and productivity, and potentially gain certain tax advantages.
A convertible financing round is a type of funding arrangement commonly used in early-stage investments. Instead of getting wrapped up in the complexities of valuation and ownership right away, everyone decides to keep things flexible and friendly. The beauty of a convertible financing round is that t's like having the best of both worlds. Sstartups get the immediate funding they need, and investors get a chance to potentially become proud owners down the road.
In a convertible financing round, investors provide capital to a company in the form of a loan (convertible note) or an investment (convertible preferred stock). The key feature of these securities is their ability to convert into equity (company shares) at a later point in time, usually triggered by a specific event.
The conversion of the securities into equity is typically tied to a future financing round or a liquidity event, such as the company's sale or initial public offering (IPO). When the conversion occurs, the investor's initial investment is converted into company shares at a predetermined conversion price or based on a predetermined formula.
The advantage of a convertible financing round is that it allows for funding to be secured quickly without the need to negotiate a valuation for the company at the time of the investment. It provides flexibility for both the company and the investors, as the conversion terms can be established later when more information about the company's value is available.
A SAFE (Simple Agreement for Future Equity) financing round is like an agreement that says, "Hey, I'll give you some cash now, and in return, I'll get a sweet deal in the future." It's like planting a seed of investment that will sprout into something exciting later.
SAFEs are often favored by both startups and investors due to their simplicity and flexibility. They allow for quicker fundraising without the need to negotiate complex valuation terms.
In a SAFE financing round, investors provide capital to a startup in exchange for the right to receive equity in the company at a later stage, typically during a future priced equity financing or liquidity event. Unlike traditional equity investments, a SAFE does not involve immediate valuation or the issuance of shares.
Instead, the SAFE represents a promise of future equity, by outlining the terms and conditions of the investment, including the conversion trigger, which determines when the investment will convert into shares. The conversion is usually triggered by specific events, such as the company raising a subsequent funding round or being acquired.
Enough theory, let’s get down to business.
George and Amy decide to open a business, using their money and some help from Amy’s father, Joe. After they register the company which has, let’s say, 1.000 shares, their cap table looks very simple. It has three lines, where George and Amy have 300 shares of common stock each, while Joe has 400 preferential shares – meaning that he gets no vote when a decision is made, but he will be the first to get dividends, before Amy and George.
It's a good period, so the company is growing, and after one year, it already has 10 employees. Amy and George decide to give some of their employees the possibility to get shares in the company if they stay long enough with the company and do their job properly. For this, they create an option pool of 200 new shares, something which will dilute all existing shareholders (more about this in another article) and implement an ESOP in the company.
Not all employees will be part of the ESOP, but those who do will receive some options which will vest over time (meaning they don’t get them all at once, but in a certain amount of time, say 3-4 years). The options could then be converted into shares. In the cap table, you may see either a share pool of 200 shares appearing, in the equity section, or you may see the same info in the securities section, if they decide to create an option pool (options are not equity). However, once the vesting starts to happen, all employees receiving shares or transforming their options into shares will show up as regular shareholders in the cap table.
Now let’s say the business needs extra money to grow. Amy and George convince an investor to give them some money as a SAFE financing round. As before, the SAFE amount will initially appear in the securities section, and as soon as the amount gets transformed into shares, the new shares will show up in the equity part of the cap table.
And so it goes, with the cap table always reflecting who’s having what from the company, either shares or securities that could be transformed into shares.
Well, there you have it - we have reached the end of our whimsical expedition through the realm of securities, shares, and other cap table elements. Armed with this newfound knowledge, you're now equipped to confidently navigate some of the intricacies of the financial world. Stay tuned for more articles which would shed more light on the remaining mysteries of equity management.
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