Cap Table

Return of the Jedi

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So, we get it.  Companies raise money, they need to set a valuation to raise said money, and they sell some of the business to raise that money (money, money, money).  There are some important things to understand in the fundraising process, and there isn’t enough time to cover them all, so I’ll stay on the ones I think are important.

Signaling

Raising money is very much so a marketing move.  There is (hopefully) positive press that can come from a capital raise.  When you raise money and announce your valuation, that sets expectations in the market – namely it shows what investors think the business is worth today.  It also figures into what investors think it COULD be worth in a few years.  Venture investors target a 3x to 5x multiple of their money in any given investment.  Generally, that means the business needs to sell for three times the amount of the last round.  So, raising money at a $250mm valuation suggests that the business should be able to be sold for between $750mm and $1.25B.  That is a lot of money.

In addition to the signal and expectations from a valuation, the existing investors’ involvement in each round matters.  If a venture investor invested in the Series A and Series B rounds, but doesn’t invest in the Series C, it doesn’t look so good.  It typically signals that the venture firm has less conviction in the future prospects of the business.  Some seed funds and early stage investors will not typically continue investing for the entire lifecycle of the business, but usually investors continue to fund a business if they think it will be successful.

Pro-Rata

This concept of continuing to support a business is demonstrated in a cap table through pro-rata investments in subsequent rounds of financing.  That is investor speak for putting up your fair share of the next round of equity.  There are a few ways to calculate what “pro-rata” represents (either your share of a future round of investment or the amount required to maintain your ownership percentage in the business).  There is a great post on Brad Feld’s blog here about pro-rata if you are interested.  Not even all VCs agree on what “pro-rata” means…

Liquidation Preference

In a standard venture deal, there is a concept known as a liquidation preference (again, covered by Brad Feld well here).  The liquidation preference is a set amount of capital that the preferred shareholders (venture investors receive preferred shares in a business with each investment) receive in preference (i.e. BEFORE) the common shareholders.  Founders and employees of the business receive their shares in the form of common shares.

This means, when the business is sold, those investors will receive a set amount before the common shareholders.  Typically, there is a 1x liquidation preference (meaning 1x the amount invested, so a $5mm capital raise will include a liquidation preference of $5mm).  There are two ways to calculate what this means: Participating Preferred Shares and Non-Participating Preferred Shares.

Participation

Non-participating shares have a right to receive either their liquidation preference OR their fully diluted ownership percentage.  Participating shares receive both their liquidation preference AND their fully diluted ownership percentage.  Let’s use an example to show how this works.

Assume that HotStartup raised one round of financing equal to $5mm at a post-money valuation of $20mm (meaning they received 25% of the business), with the founders retaining the remaining 75% of the business in the form of common shares.  In any sale of the business for less than $5mm, if there is a liquidation preference – the preferred shareholders would receive all of the capital.  If the business sells for more than $5mm, there are a few different outcomes.

If the shares are participating preferred shares, in a sale of HotStartup for $30mm, the investor would receive the first $5mm (their liquidation preference) AND 25% of the remaining $25mm ($6.25mm).  The investor would return a total of $11.25mm, with the founder getting only $18.75mm.

If the shares are non-participating, the investor has the right to EITHER the liquidation preference OR their ownership percentage of the total sale.  So in our last example, they would get EITHER their $5mm liquidation preference OR their 25% of the $30mm ($7.5mm).  Obviously they would take the $7.5mm, leaving $22.5mm for the founders.

The difference between participation and non-participating shares is huge (in our simple example, the difference between $3.75mm!).  Despite this, I have encountered countless management teams that do not know if the investor’s shares in their business are participating or non-participating.  For reference, according to PitchBook, 60% of rounds in 2013 were non-participating, with 30% have uncapped participation and 10% have a cap on the participation (meaning a limit to the amount that the investor may receive both their liquidation preference and ownership percentage).

There are TONS of nuances within a term sheet, and I highly encourage every founder to have an experienced lawyer look through the terms of a deal on your behalf.  There is too much that can be slipped into a term sheet and the legal documentation, all of which can have an enormous impact on the potential economics.

This was a long post, and was one of a three part trilogy (part one here, part two here).  There is a lot involved in a capitalization table, and even more nuances in the legal documentation.  There is no harm is asking for help, there are tons of resources, and lawyers are always available (at their normal billable hours…).  Don’t sign a contract unless you know what it means, it could cost you literally millions of dollars.

The Empire Strikes Back

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The second stage of the Cap Table Trilogy, The Empire Strikes Back (really no correlation to the Star Wars Trilogy, but I like Star Wars, so we’re sticking with it).  At this point, HotStartup has built an amazing product, we’ve figured out our business model, and we are starting to really scale.  $5.5mm has been invested by some great VCs and Seed investors.  Time for that Series B.

Series B

This is the time to get some real money.  We need bigger investors who are looking for the next three to five years, with some deep pockets.  The investors skill set at this point isn’t focused on business models and early stage operations, but truly has a grasp on how to scale, and scale fast.

Thinking about HotStartup, we MAY have generated a couple million dollars of revenue in the last twelve months, but we are likely somewhere around that $5mm to $10mm range.  In order to start really being interesting to a potential acquirer or to think about going public, we need to hit a minimum of $50mm.  Growing by 10x in 5 years means we need to grow 59% annually – that’s a LOT.  Big growth needs big dollars.

Valuation will also increase with this raise, and hopefully quite a bit.  Thinking about the multiples, if we were able to generate somewhere around $5mm, a pre-money valuation of $25mm (5x revenue) would be fair.  Including the $10mm ask, we would be at a $35mm post-money valuation (7x revenue), something that is within reason.  This raise represents a 28% sale of the equity, and will dilute all the prior investors (remember, we assume no participation from old investors in new rounds).

Series C and Series D

Here is where things start to reach more normal, reasonable multiples for business.  Things are based on the revenue of the business and the performance.  We get a lower premium based on our potential, and a larger premium based on our business.  Customers should be adopting the product, buying lots, and really NEEDING our product.  Without HotStartup, the Fortune 500 would fall apart.  We’ve spent $15.5mm on the product and are starting to scale at more than 50% annually.  Let’s step on the accelerator, throw gas on the fire and really blow this out of the water (generic business terms always make you sound sophisticated, and are never a bad choice).

We need some serious cash to invest in the sales and marketing department (S&M).  Research and development (R&D) are important, and should keep up with the innovation cycle in our business, but we already have a fully functioning product that is performing in the market.  We won’t spend less on innovation, but we likely aren’t growing the R&D budget at 100% annually anymore (every busines is different, so I wont say that all business slow down their spend on R&D, just making an assumption from my experience).  General and administrative (G&A) costs should start to be leveling out, as we should have a C-suite in place (or will have a C-suite in place post-Series C).  We either retained the founder as CEO, or brought in a serial entrepreneur that knows the space; the CTO is one of the founders and is leading the product and innovation; a CFO is helping manage the equity partners, board members, banks, financial planning, audits (you know, the fun stuff!); and the COO is making sure the place isn’t falling down, keeping the business partners in-line and making sure our amazing product is always delivered the way it should be.

We’re investing to grow the business.  Each dollar we invest will add to the growth of the business, and hopefully we can measure how this works.  In a recurring revenue model there are lots of great financial metrics we can use to measure our performance (ARPU, AMPU, CAC, CLTV, Churn, etc.), making it easy to understand why investing $20mm of cash into a business that is spending $5mm to $10mm a year is totally logical.  I promise venture investors are not dumb; there are always metrics that justify the investment.

So, what does this all mean for HotStartup?  Well, we are going to need to balance our cash needs a little more carefully now.  If we take a LOT of money in the Series C, we will be taking on dilution and cash at a time that we might be able to spend it as quickly as we would like.  If we wait to take cash, we might miss an opportunity to grow the business at the exponential rate we need and wont maximize the value of the business.  Here is where the financial expertise of a good CFO really matters, this is when we can start to really explore bank lines, venture debt, tranched equity raises, convertible equity notes, follow-on invetments, vendor financing, etc.  For the purpose of understand how to build a cap table, I’ve put together some assumptions around valuations and capital raises based on the PitchBook VC fundraising report from Q4 2013 (embedded below as well).  There are a TON of great insights in there regarding the valuations of business, investor rights, and standard terms.  I encourage everyone who ever thinks about raising money to look in there and see what the REAL industry averages are for potentially expensive investment terms (which we will cover in the next section).

After all of the capital raised, and all of the money invested into the business – we as founders would own ~26% of HotStartup.  That is really, really good.  As one of two co-founders with 80% of that amount, we would have 10.6% of the business, worth $16mm at a $152mm post-money valuation.  Not bad, but you know what’s really cool? A billion dollars (in my most sly JT as Sean Parker voice).

Seed through Series D Cap TablePitchBook_4Q2013_VC_Valuations_and_Trends_Report