Cap table dilution math - Valuations in share prices

This is the 4th part of the Pro Cap Table training course. In this series we go through the basics you need to know, then worksheet by sheet so you know how to make a seriously kick-ass cap table.

Introduction

We are not getting into my Pro Cap Table for the purposes of illustration. Whether you have it yet matters not. There is still loads to learn about cap tables to get smarter I’m going to teach you.

We are starting out with the Format sheet in the Pro Cap Table. There is technically nothing you need to actually change, but there is a tonne you ideally need to understand!

I’ll take you through each section and give you some reading to do if I’ve done it for you.

Here is the sheet:

Note conversion

A lot of startups do their first angel and/or seed round in a convertible note (Some might use a SAFE note).

I’m not going deep on these, so this is the tip of the iceberg for learning if you need to use a note as part of your fundraising.

I’m dropping you in the deep end, so this is going to be a bit of a mind screw.

There are three ways to calculate the conversion of convertible notes when they turn into equity in your startup at a “qualified financing round”. Everyone thinks convertibles are meant to be simple, but they are the opposite once you go down the rabbit hole.

I’ve written a big blog and a short blog on convertible note conversions. Yes, it is complicated but you need to get your head around it if you are to do convertible notes.

• Simple version on convertible conversion
• Detailed version on convertible conversion

In the model, you only need to pick the method of conversion from a drop-down menu and the calculations are done for you. So you only need to know (or negotiate) the method and use the drop-down to apply it.

Isn’t it cool the model makes it that simple? Yes, but that makes it dangerous as you actually need to understand what this means so that you can negotiate your term sheet with convertible note holders if you didn’t do so properly when you wrote the notes!

Pro rata choice

Pro rata means maintaining your ownership as an investor. This matters a lot to certain investors.

I’ll let Fred Wilson from USV explain:

The “pro-rata right” is the right to continue to participate in future rounds so that you can maintain your ownership. Let’s make it concrete with an example. You invest $50k in a seed round at a $5mm cap and own 1% of the company. The next round is a $3mm round at $9mm pre, $12mm post. If you don’t participate, you will be diluted 25% and will then own 0.75% of the company. On the other hand, if you buy 1% of the round, a $30k investment, you will continue to own 1% of the company. Your “pro-rata right” in this situation is a $30k allocation in the next round.

In the Pro cap table template, I made it so you can automatically calculate the pro rata. This makes it simple to do a few things:

• Calculate what investors’ pro rata actually is
• Plan for pro rata without a lot of calculations when you want to run some scenarios

There are two options in the model:

1. Manual: You manually will input if there is any pro rata and what the $ investment amount will be
2. Pro rata: The model automagically calculates the pro rata for investors. Let’s say they own 20% and would be diluted 20%. The pro rata would be to increase their stake 4% from 16% to 20% to maintain their ownership

ESOP types

There are a couple of types of shares (read options until they convert into shares) that staff can own. The three main ones (depending on your country, this is for the USA) are:

• RSU: Restricted Stock Units
• ISO: Incentive Stock Options
• NSO: Non-Qualified Stock Options

If you need to know about these, this blog is decent.

TBH, you should talk to a lawyer once you start down this road.

For the purposes of this model, to be generic for everyone, bucket things up into RSUs and Options (ISO and NSO).

RSUs are a bit weird. Accounting for these is funky. First, you need to issue RSUs out of your ESOP. Then you adjust them out of the ESOP to the Common schedule and mark them as RSUs. The RSUs are basically vesting shares instead of vesting options in a sense. If you look at the filled-in version of the Pro cap table you can see how the double entry is done and the commentary.

The ‘options’ on the other hand are a lot more simple in comparison. You just input them in the ESOP sheet. There is a bunch of complicated math done to size your ESOP pool and what is left after you issue options out of the ESOP pool. Since investors will ask you to increase your option pool between rounds, you will need to know how much you have reserved, how much you have granted, and what is left. The model does the math for you (Yes, it took me forever to figure out!).

Vesting schedule

Once you grant shares or options, unless you are a silly billy, you will always have a vesting schedule.

The main things you need to know are:

• Cliff: You don’t get anything until you have reached the cliff, or the shares go off the cliff. This is typically a year
• Vesting term: This is the total period before you get 100% of the shares. This is normally 4 years
• Vesting period: You get a fraction of your shares every period, which is either monthly or quarterly. Monthly is better, daily is not normal but you would do. Basically, if you have monthly vesting and you leave one day before the end of the month, you don’t get that month

 

There are three options for you to pick from with a drop-down so the math works with a mouse click.

I have made 3 templates which cover 99% of what you might want to do. You pick the option you want from a drop-down menu and it’s done.

Accelerated vesting

This means you get all your shares at an exit. It’s a big FU to the vesting schedule we just talked about. Everyone other than the person who has this clause hates it.

If you get acquired and you have only vested 50% of your shares, acceleration means you now get 100%…. if you meet the single or double trigger clause.

The model gives you a lot of acceleration flexibility. For these purposes, you just pick if there is acceleration or not.

Issuance of common shares

I mentioned that how you manage share issuance and changes is the really fiddly bit. This does not affect the conversion of any shares, it’s a note for you to track things when they happen.

To mix things up, treat each line in the ledgers as a series of events, not as one line that says this is what they own. Every time you change something, you add a line and then the totals are added and deducted to get to the totals. I’m explaining this terribly, so let me explain the options:

• Original issuance: you give shares/options to people, you probably thought that was all you did
• Restricted stock from ESOP: Mentioned above. When you issue RSU from the ESOP, you want to put it in the common sheet. This is the note you make
• Share transfer: There are a few reasons for this, the most obvious is taking shares from one person and moving it to another person
• Balance after repurchase: This can be from a transfer of shares from one investor to another, repurchasing shares from a terminated founder who had RSUs, etc. You make this note when you need to do non-normal accounting (as you fired someone etc). You’re moving shares from one ledger to another or one person to another
• Options exercise: You grant options to staff, and they look forward to exercising them into shares so that they own part of the company for real real! You note this when it happens, so shares go from the ESOP to the Common ledger. The same thing applies when convertible notes convert into the class of underlying class of stock.

This all probably sounds like a lot, and yes it is! This isn’t the baby cap table, it’s the PRO cap table. You can keep the model simple and not do a lot of this crazy stuff then hire a lawyer to do everything for you, but if you want to be totally on top of things, this is the sheet for you. There’s nothing else like it.

I’m proud of you for getting through this. I taught myself, ha!

There we go. Let’s get moving to the next episode.

Read next step

14 parts in this guide

You can jump to a section if you prefer:

1. What is a cap table and other important questions
2. Cap table dilution step-by-step example
3. Cap table dilution math
4. Starting the cap table (The drop-down menus we need)
5. Shareholders sheet
6. Deal calculations
7. The cap table sheet
8. The assumptions sheet
9. Individual shareholder returns sheet
10. Returns waterfall calculation
11. The ESOP sheet
12. The Common sheet
13. The convertible notes and warrants sheet
14. The preference shares sheets (From Series A to I)