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Sunday, February 5, 2023

Preparing Your Cap Tables the Right Way

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Succeeding in Your Business

By Cliff Ennico

“We have kind of a ‘good news, bad news’ problem in our business.
On the one hand, a local angel investor has offered to buy 15% of our company for $300,000.

On the other hand, we don’t know exactly who owns our company. My brother and I inherited my father’s 80% share in the business when he died last year, and the remaining 20% is owned by several family members.

The problem is that toward the end of his life, Dad made promises to a number of people — mostly long-term employees, distant relatives and at least one of his nurses — to give them shares in the business, but didn’t keep any documentation. The angel investor is asking for an ownership chart showing all people who may have an interest in our company, and we can’t put it together because we can’t figure out who was promised what. What can we do?”

Forget about balance sheets, income statements and cash flow projections. When it comes to raising money from investors, often the single most important document is the capitalization table (“cap table” for short).

A cap table is nothing more than a list of the company’s owners, showing the number of shares and/or the percentage of the company they own. Sounds simple, right?

But there are two different cap tables. The first shows the “actual” ownership of stock in the company as of a particular date. This table is important because it shows who is entitled to vote when the owners have to vote on something. (Holders of options and warrants don’t count.) In this reader’s case, putting together the “actual ownership” table is easy: She should include only herself, her brother and the family members owning the remaining 20%. (When doing this, by the way, it’s a good idea to include mailing and email addresses as well as the names so it’s easier to send them notices of meetings, tax returns and other necessary communications.)

The second cap table every business needs is the “fully diluted” cap table, and it’s much trickier to prepare. In addition to the actual owners of the business, a “fully diluted” cap table also contains the names and address of people who own options, warrants, convertible notes and other instruments that can be converted into stock in the future.

When those conversions happen, the existing owners will be “diluted” — their percentage ownership of the business will decrease in order to accommodate the new owners. Investors always want to see how their investment will be diluted if everyone holding options, warrants and convertible instruments were to convert into stock at the same time, which is why they always ask for a “fully diluted” cap table.

The fact that your angel investor wants to see a “fully diluted” cap table means he wants to get a number of shares that will equal 15% of your company AFTER all of the options, warrants and other convertible instruments have been converted into cash. (Since bank loans are almost never convertible into stock, you don’t have to include those on your “fully diluted” cap table but it’s good to include them anyway as it gives investors a more complete picture of how much debt the business has.)

And therein lies the rub: Entrepreneurs (like this reader’s father) often fail to keep track of the promises they make to give people stock in their companies.

The good news here is that verbal promises of any kind are seldom enforceable. An ancient law called the statute of frauds (https://en.wikipedia.org/wiki/Statute_of_frauds) requires most enforceable promises to be in writing, and a promise to give someone something when you die is totally unenforceable unless it’s in a last will and testament.

So it sounds like this reader has little to worry about promises her father may have made to distant family members, his nurses and the like.

The employees, however, are a different situation. While these promises are probably also not enforceable, you don’t want to tick off loyal and long-standing employees who have contributed to your business’s success.

What I would recommend here is that this reader put together an “option plan” for all of the restaurant employees, granting them options to acquire a small piece of the company (no more than 5% to 10%) vesting over a period of one to five years. That way, they have an incentive to stay with the company and are less likely to complain that they were shortchanged by the father’s death.

Also, if any of the distant relatives, nurses or other people who knew your father come out of the woodwork later on claiming they own a piece of the company, you can make them “consultants” to the company and give them options under the plan to make them go away.
The option plan should be put into place before the angel investor comes on board and should be mentioned in the “fully diluted” cap table.

Cliff Ennico ([email protected] ) is a syndicated Cliff Ennico ([email protected]) is a syndicated columnist, author and former host of the PBS television series “Money Hunt.” This column is no substitute for legal, tax or financial advice, which can be furnished only by a qualified professional licensed in your state. To find out more about Cliff Ennico and other Creators Syndicate writers and cartoonists, visit our webpage at www.creators.com.


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