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Capitalization, Cap Table, & Initial Accounting

This article will serve as an explanation of some of the basics around the formation and structure of a corporation.  I am using examples for a typical corporation, but many of the concepts can apply to LLCs and the issuance of units to represent membership interests instead of stock.

I)  Capitalization

People need to have a basic understanding of what capitalization of a company means before they can really understand what a cap table is.  Capitalization is a term that deals with the capital structure of the company.  It is made up of the amounts and types of financing used by a company. Types of financing include common stock (which can include founder’s stock), preferred stock, retained earnings, and debt.  It provides a general overview of the company’s debt and equity.  You add the long-term debt, equity, and retained earnings together for the normal total number.  Most people are familiar with a version of this called market capitalization or market cap.  That is essentially taking the number of issued shares of common stock times the company’s current price per share for a total number of market cap.  It is one number used to determine an estimated value of the company as a whole.  It can also change due to accounting changes due to various transactions.

II)  Cap Tables

A cap table is basically a summary of the company’s capitalization and ownership.  There are various forms of cap tables used and there is no one template that is the agreed-upon version of a cap table.  Although they can give a summary overview, the detailed version needs to be put together from the start of a business which includes specific details about who owns what from day one.  It could include things like a historical timeline of stock issuance with the date of issuance, name of the shareholder, number of shares, consideration given in exchange for the shares, and some accounting entries related to that consideration (cash, services, etc.).  It could also be less detailed with a general overview of the total number of shares of stock issued and amounts still available for issuance.  You want to keep the detailed version with actual shareholders’ names internal and only use a summary grouping such as “founders”, “seed investors”, “Series A Preferred”, “Series B Preferred”, “employee options”, and so on.

Some other common terms used in connection with a cap table are pre-money valuation, post-money valuations, price per share, dilution, options, warrants, percentage of ownership, and preferred stock.  It is usually easiest to create a cap table through Excel or an accounting program, such as QuickBooks.  You can purchase and download templates online; however, they are not all that complicated to put together on your own if you understand the basics of capital structure and a little accounting and finance.

A very simple example of a cap table would be:

Type             Value           Price per Share      Shares        Total Ownership

Founders –   $5,000           $1.00                     5,000                50%

Investors-     $5,000           $1.00                     5,000                50%

Total-           $10,000                                      10,000               100%

You will normally want to include variations in your cap table that show what happens if more shares are issued, such as upon someone exercising their option or warrant right to purchase stock or additional funding rounds.  It should show clear calculations of valuation and percentages of ownership both pre-money, post-money, and fully diluted post-money (if you assume that any options are exercised, warrants are exercised, or a convertible note is converted and result in stock issuances).  An investor wants to see exactly what they will own in all possible scenarios.

III)  Initial Accounting Practices

I will discuss the initial accounting that goes along with capitalization to expand upon the cap table preparation.

When you first form the corporation, you list in the articles of incorporation filed with the secretary of state the total number and type of shares that are “authorized” to be issued.  Think of those like a total pool of available stock in the company’s bank to issue when needed.  For purposes of this example, let’s say the company authorizes 1,000,000 shares of common stock and 1,000,000 shares of preferred stock.  Although these days you often don’t have to list what they call a “par value” for the authorized stock, it is easiest just to pick something like $0.001 as a par value for accounting purposes.  The initial issuance to founders of 500,000 shares of the 1,000,000 pool of authorized stock is in exchange for them putting in $50,000 of their own money into the company would have an accounting entry like this:

Account Name                                                       Debit                Credit

Cash                                                                     50,000

Additional Paid-In Capital (APIC)                                                  49,500

Founder’s stock (500,000 shares x $0.001 par value)                     500

Each side (both debit and credit) totals 50,000 so the accounting entry reconciles and is in balance.  Both APIC and founder’s stock go towards the overall equity and capital of the company, so the balance sheet would show assets of $50,000 in cash and owner’s equity of $50,000 total with no liabilities.  There would still be 1,000,000 shares authorized and 500,000 shares issued as the capitalization structure.  The founders would own 100% of the company as you only look to what they own out of the total amount issued of 500,000, not the amount authorized since those have not yet been issued.  When the remainder is issued out of that pool, the founders would get diluted down from 100% ownership to as low as 50% if the rest of the authorized are issued to new investors.  This would result in a price per share of $0.10 per share ($50,000 investment divided by 500,000 shares).

Many founders try to figure out how to account for the founder’s stock issuance if they didn’t put much cash into the company and got a large number of shares (e.g. 1,000,000 shares issued in exchange for $500 initial investment = $0.0005 per share price).  There can be tax and accounting implications, but you shouldn’t be that concerned about that low of a share price since it is really more of an accounting entry and not a real determination of the value of the company.  If the company is that concerned about how that may look, they can make the initial issuance at a higher share price (and bring up the valuation) if there is a legitimate basis or valuation model to support it.  One thing that would stick out is if you started the company with a $500 valuation based upon $500 cash being contributed and the next day the company is trying to raise $500,000 for 50% of the company based upon a valuation of $1,000,000.  You would need to justify where the value is coming from (e.g. future revenues, contract deal, patent acquisition).  Valuations in early-stage companies can vary widely and are extremely difficult to accurately forecast, so don’t get too caught up in a low per-share price.

When it comes to initial capitalization, the founders typically do need to show that they contributed something in exchange for their shares.

In many cases, you don’t need to worry about including things like par value on a cap table, but the total values involved with the stock issuances should be.  Often you will see the more detailed accounting entries if you look at a public company’s financials in the statement of stockholders or owners’ equity.

 

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