February 2024

# Understanding the Basics of Cap Table Math in Start-Ups

### Summary

• Before a company raises its first round of financing, it’s crucial that the founding team understands how an equity round will impact the company’s capitalization table (“cap table”) and the founders’ ownership in the company.
• An investment will increase a company’s post-money valuation, but it will also dilute the founder’s ownership percentage (i.e., the pre-money capitalization).
• The timing of an employee stock option pool (“ESOP”) increase and conversion of outstanding notes—that is, whether they occur before or after an equity investment—can have significant implications for a start-up’s valuation, investor share price, and founder dilution.
• By deferring ESOP and note conversion actions until after the investment, the new investor and the noteholders will share in the dilution, reducing the total dilutive impact on the founders.

Before a company raises its first round of financing, it’s crucial that the founding team understands how an equity round will impact the company’s capitalization table (“cap table”) and the founders’ ownership in the company. This article illustrates an easy way to conceptualize this impact and calculate a company’s post-money cap table following a financing.

## Initial Share Distribution

Before we delve into the numbers, let’s imagine a scenario: Alice and Bob are the sole founders of XYZ Tech and are considering their first major financing round. Currently, Alice and Bob each hold 500,000 shares of XYZ Tech representing 50 percent of its outstanding equity.

The table below represents XYZ Tech’s cap table immediately prior to the financing:

 Shareholder Shares Ownership Alice 500,000 50% Bob 500,000 50% Pre-Money Capitalization 1,000,000 100%

## Raising Cash – Transforming the Cap Table

### Example 1: Initial Capital Raise Impact on XYZ Tech’s Cap Table

Assume that Alice and Bob meet with a prospective investor who is interested in investing \$1 million in XYZ Tech based on a pre-money valuation of \$15 million. By accepting these terms, XYZ Tech will receive an investment of \$1 million in exchange for issuing equity to the new investor. This will increase XYZ Tech’s post-money valuation to \$16 million (i.e., the company had \$15 million of value, and an additional \$1 million in cash was added to its balance sheet), but it will also dilute Alice and Bob’s ownership percentage of XYZ Tech (i.e., the pre-money capitalization).

Using these terms, we can calculate XYZ Tech’s post-money capitalization table using the following process:

1. New Investor Ownership Percentage: The \$1 million investment translates into a 6.25 percent ownership stake in XYZ Tech on a post-money basis (\$1,000,000 investment / \$16,000,000 post-money valuation).
2. Founders Post-Money Capitalization Ownership Percentage: Alice and Bob currently own 100 percent of the company. After the investment, their combined ownership will adjust to accommodate the new investor’s 6.25 percent ownership stake, leaving them with 93.75 percent of XYZ Tech’s post-money capitalization (100% – 6.25%).
3. Post-Money Capitalization Shares: Post-money capitalization shares can be calculated by dividing the pre-money capitalization shares by Alice and Bob’s remaining ownership percentage after the investment (i.e., the founders’ post-money capitalization ownership percentage calculated in Step 2) (1,000,000 / 93.75% = 1,066,667).
4. New Investor Shares: To determine the actual number of shares that the new investor receives, we multiply the new investor ownership percentage we calculated in Step 1 by the post-money capitalization shares calculated in Step 3 (6.25% x 1,066,667 = 66,667).
5. Post-Money Cap Table: The final step is to update the cap table with the new share distribution. Optionally, you can include a column for the value of the shares held by each shareholder. This value can be calculated by multiplying the post-money ownership percentage by XYZ Tech’s post-money valuation. The revised cap table, with the optional “Value” column, would look like this:
 Shareholder Value Shares Ownership Alice and Bob \$15,000,000 1,000,000 93.75% New Investor \$1,000,000 66,667 6.25% Post-Money Capitalization \$16,000,000 1,066,667 100%

## Option Pool Increase and Convertible Notes

### Example 2: Incorporating Convertible Notes and the Employee Stock Option Pool Prior to Investment

Now assume that XYZ Tech has an additional financial instrument in play prior to the financing: \$500,000 in convertible notes that will convert at a 20 percent discount. For those unfamiliar with convertible notes, they are short-term debt that will usually convert into equity at the most favorable price per share derived from either a valuation cap or a discount during a company’s next equity financing. For this example, the notes convert using a discount rate.

Assume further that XYZ Tech is required to create an employee stock option pool (“ESOP”) equal to 15 percent of its post-money capitalization as part of the terms of the investment.

A simple way to calculate the post-money capitalization table is to begin by determining the ownership percentages of the new investor, the ESOP, the noteholders, and the founders, as follows:

1. New Investor Ownership Percentage: The new investor still receives a 6.25 percent ownership stake in XYZ Tech’s post-money capitalization (\$1,000,000 / \$16,000,000).
2. ESOP Ownership Percentage: XYZ Tech is required to allocate an option pool equal to 15 percent of its post-money capitalization.
3. Noteholders Ownership Percentage: The noteholders’ ownership percentage can be calculated by dividing the total value of the convertible notes after adjusting for the discount (\$500,000 / 80% = \$625,000) by the post-money valuation: (\$625,000 / \$16,000,000 = 3.90625%).
4. Founders Post-Money Capitalization Ownership Percentage: We calculate the founders’ post-money ownership percentage using the same method as before, except now we need to adjust to accommodate the new investor, the ESOP, and the convertible notes (100% – 6.25% – 15.00% – 3.90625% = 74.84375%).

As in Example 1, to calculate the total post-money capitalization shares, we divide the total pre-money capitalization shares by Alice and Bob’s remaining ownership percentage after the investment (1,000,000 / 74.84375% = approximately 1,336,117). Now we can determine the share amounts for each category and update the cap table with the new share distribution:

• ESOP Share Calculation: Multiply the ownership percentage by the total number of shares (15.00% x 1,336,117 = 200,418 shares).
• Noteholders Share Calculation: Multiply the ownership percentage by the total number of shares (3.90625% x 1,336,117 = 52,192 shares).
• New Investor Share Calculation: Multiply the ownership percentage by the total number of shares (6.25% x 1,336,117 = 83,507 shares).
 Shareholder Value Shares Ownership Alice and Bob \$11,975,000 1,000,000 74.84375% ESOP \$2,400,000 200,418 15.00% Noteholders \$625,000 52,192 3.90625% New Investor \$1,000,000 83,507 6.25% Post-Money Capitalization \$16,000,000 1,336,117 100%

### Example 3: Incorporating Convertible Notes and the ESOP After the Investment

The timing of the option pool increase and conversion of outstanding notes or simple agreements for future equity (“SAFEs”)—that is, whether they occur before or after an equity investment—can have significant implications for a start-up’s valuation, investor share price, and founder dilution.

• Before the New Investment: Treating an option pool increase or the shares issued upon conversion of outstanding notes or SAFEs as occurring prior to the new investment effectively lowers a company’s post-money valuation and increases the dilutive impact on prior investors. This results in a higher share count before the investment and thus a lower share price for the new investor. If you compare Examples 1 and 2 above, you can see that including the ESOP and the noteholders in the company’s pre-money capitalization, before the new investment, dilutes Alice and Bob’s ownership in XYZ Tech and the effective value of their investment by 18.91 percent (93.75% – 74.84%).
• After the New Investment: Treating an option pool increase or the shares issued upon conversion of outstanding notes or SAFEs as occurring after the new investment means that the new investor will share some of the dilution with the current cap table. This results in a higher share price for investors and less dilution for the founders initially.

To illustrate this concept, let’s continue our ongoing analysis of XYZ Tech’s cap table from Example 2, except with a critical timing difference: the ESOP increase and the conversion of the convertible notes will occur after the investment. Since the convertible notes and the ESOP occur after the investment, we calculate the shares issued to the new investor using the same calculation as in Example 1.

1. New Investor Ownership: The new investor’s \$1 million investment translates into a 6.25 percent ownership stake in XYZ Tech on a post-money basis, immediately prior to the conversion of the notes and the ESOP (\$1,000,000 / \$16,000,000 post-money valuation).
2. Post-Money Shares before ESOP and Note Conversion: Using the steps outlined in Example 1, we know that Alice and Bob’s one million shares represent 93.75 percent of XYZ Tech’s outstanding equity and that the shares allocated to the new investor are equal to 66,667. Therefore, the total capitalization of XYZ Tech immediately after the investment but before the conversion of the notes and the option pool increase is 1,066,667 shares (1,000,000 / 93.75%), which represents \$16 million from a valuation perspective.
3. Note Conversion: The number of shares issued to the noteholders can be calculated using the same methodology as before, except that the ownership percentage for the noteholders is multiplied by the number of shares calculated in Step 2 above (3.90625% x 1,066,667 = 41,667).
4. Calculating Total Post-Money Capitalization: We can use the same methodology outlined above to calculate the total post-money capitalization, except that now both the new investor and the noteholders are included with Alice and Bob in the capitalization calculations. This means that we can calculate post-money capitalization by dividing 1,108,334 (1,066,667 + 41,667) by 85 percent (100% – 15% (ESOP)), which equals 1,303,922.
 Shareholder Value Shares Ownership Alice and Bob \$15,000,000 1,000,000 76.6917% New Investor \$1,000,000 66,667 5.1128% ESOP \$2,400,000 195,588 15.00% Noteholders \$625,000 41,667 3.1955% Post-Money Capitalization \$19,025,000 1,303,922 100%

This scenario illustrates how the timing of the ESOP increase and note conversion influences the cap table. By deferring these actions until after the investment, the new investor and the noteholders share in the dilution, reducing the total dilutive impact on the founders (Alice and Bob) by 1.848 percent.

## Summary

In conclusion, mastering cap table math is vital for start-up success. Founders must comprehend the impact of financing on ownership and valuation to make informed decisions. This guide simplifies the complexities, empowering entrepreneurs with the knowledge to navigate equity distribution and maintain the integrity of their vision and ownership.