Startup Cap Table 101: Reflecting a New Equity Financing

In the first blog post about cap tables, we talked about setting up equity compensation pools.  In this blog post, let's learn how to add a new equity investment to the cap table.  Let's assume that our startup has 2,000,000 founder shares outstanding, a 500,000 equity compensation pool, and a pre-money valuation of $1 million.  The investor is investing $200,000.

So, the cap table pre-financing looks like this:

                           Type of shares        # of shares        % fully diluted
Founder                Common                1,000,000            
Founder                Common                1,000,000
Pool                      Common                500,000
Total                                                    2,500,000            100%

To get the price per share that the investor will pay, we use the following formula:
pre-money valuation / # of shares outstanding, which in our case will be $1 million / 2.5 million shares = $0.40 per share.

Investor will own 16.7% of the company following its investment.  We get there by using the following formula: Investment amount / post-money valuation = % ownership, which in our case is $200,000 / $1,200,000 = 16.7% (BTW, post-money valuation equals pre-money + the amount of investment).

To find out the number of shares that the investor will get, we need to divide the investment amount by the price per share, which is $200,000 / $0.40 = 500,000 shares.

So, our new post-investment cap table looks like this:

                            Type of shares        # of shares        % fully diluted

Founder                Common                1,000,000            33.3%

Founder                Common                1,000,000            33.3%

Investor                Preferred                500,000               16.7%
Pool                      Common                500,000               16.7%

Total                                                    3,000,000            100%

We can get the same results by using different formulas.  Imagine that, as in the previous example, all you know is the following: (i) number of outstanding shares pre-financing, (ii) the startup pre-money valuation, and (iii) the amount of financing.  

                            Type of shares        # of shares        % fully diluted

Founder                Common                1,000,000            IV

Founder                Common                1,000,000            IV

Investor                Preferred                II                           16.7%
Pool                      Common                500,000               III

Total                                                    I                         100%

Using the known information, we can fill in the missing amounts.  We know that the investor will own 16.7% post financing by dividing $200,000 / $1.2 million post-money valuation.  

Let's solve for I:  We know that III+IV = 83.7%.  We also know that 83.7% equals 2,500,000 shares.  This means that I equals 3,000,000 shares (2,500,000 / 0.837).  

Let's solve for II:  If 100% equals 3,000,000 shares, then 16.7% will equal 500,000 shares.  Therefore, investor will receive 500,000 shares.  

Let's solve for III:  We can calculate III by dividing 500,000 shares by the total 3,000,000 shares.  

Let's solve for IV:  With the pool and investor shares taking 16.7% each, we have 66.6% left, split equally, to the two founders holding 2,000,000 shares.  This gives us 33.3% ownership for each founder.  

Since we know that a $200,000 investment buys 500,000 shares, then the price per share will be $0.40.

Although some numbers may be somewhat off due to rounding errors, the formulas should work.  

Next, time, let's see how to reflect the conversion of convertible notes at the time of the financing.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.

Startup Cap Table 101: Introducing an Equity Compensation Pool

 I have to admit: cap table calculations are not easy and not all startup lawyers enjoy this part of their jobs.  However, no matter how hard it can get, being able to make sense of the cap table is an essential skill for startup lawyers.  Since I have just finished teaching this to students at Fordham Law's Entrepreneurial Law class, I thought I would share some of the calculations here with you.  

Let's start with your basic cap table:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        50%
Founder B            Common        1,000,000        50%
Totals:                                         2,000,000       100%    

This example shows that the startup has two founders, each holding 50% of the issued and outstanding stock.  BTW, this startup has authorized 5,000,000 shares of common stock, $0.00001 par value.

The Board of Directors has just approved the issuance of an equity compensation pool of 20%.  The stockholders of the company (ie, both founders) have also unanimously approved the pool.  Now, let's reflect it in the cap table:

First, let's find out how many shares will be allocated to the pool.  To get there, we use the following formula: 

Total New Shares Outstanding = Existing shares outstanding / 1 - options pool %, which means: 2,000,000 shares / 0.8 = 2,500,000 shares.  So, with the pool, the startup will have 2,500,000, which means that the pool will have 500,000 shares of common stock allocated to it.  Our cap table now looks like this:

                            Stock Type        Shares        Fully Diluted Stock %
Founder A            Common        1,000,000        40%
Founder B            Common        1,000,000        40%
Pool                      Common        500,000           20%
Totals:                                         2,500,000       100%    

As you can see, the creation of the pool diluted both founders.  Obviously, if the pool were to be created after an equity financing event, it would dilute both the investors and the founders.  That's why investors always want the pool shares to be created on a pre-money basis, diluting the founders alone.  

In the next blog post, let's look at how to add a Series A financing to this cap table.

This blog contains general information about legal matters. The information is not advice, and should not be treated as such. Communication of information by, in, to or through this blog and your receipt or use of it: (1) is not provided in the course of and does not create or constitute an attorney-client relationship; (2) is not intended to convey or constitute legal advice; and (3 is not a substitute for obtaining legal advice from a qualified attorney. Pursuant to Rule 1-400(D)(4), you are notified that this blog may constitute a communication or solicitation concerning the availability for professional employment of a member or a law firm in which a significant motive is pecuniary gain. For more information on this topic, please contact the author, Arina Shulga.