Cap Table basics & Cross-Border insights

At a recent event hosted by TiE Mumbai, Rajinder Balaraman (Director, Matrix india) and Shantanu Surpure (US based Corporate lawyer) discuss the basics of Cap Table management and cross-border insights. Read on to know more.

Rajinder: Shantanu is someone we have known for a long time now. i think Shantanu used to be based in india. He was an advisor for many companies that we were evaluating back in 2012 and the Bombay ecosystem was taking off. Since then, he has now moved to the Valley. He spends his time across the Valley and in Asia. And he advises companies on multiple things largely related to the legal

The reason we thought we will do this was cap tables is a topic that many people are interested in especially as they are starting out

Shantanu, thanks for doing this. Really appreciate it. First off, i think what is the significance of cap table? Why is it important? And how is it different in india versus the US?

Shantanu: Sure. Thanks, Rajinder. And thanks everybody for showing up on Monday evening. it’s not really popular particularly heavy traffic time, so thanks again for coming. So as Rajinder mentioned, i was in india. i would like to i was one of the personally involved in the ecosystem here since 2007. i am now back in the US in the Valley. i am a corporate lawyer from Columbia based in the Palo Alto area. You know that’s the epicenter of startup scene VCs

So at the very outset what is cap table. Really it’s some kind of table – Excel or any other spread sheet. Excel are pretty popular. in the US you also have number of software providers that are pretty popular online and see many of these in india. Fundamentally it is the way that you decide the equity in the company. But it more than that, it’s the story of the company. And in fact - and the reason lawyers are involved in cap tables because the cap tables is based on legal documents. But one of the key differences i see that the lawyers are heavily involved in the cap tables in the US.

Here i think cap tables probably much more CFO or the founder is more involved in that. There, they tend to be little bit hands on on that approach. But i think before i get in, i want just to revise three terminologies that i think everybody should in cap table. So one is the pro forma cap table. So probably – many of you have heard this word pro forma. That term and basically what it means is as matter of form.

Pro forma simply means that when you are doing the cap table, you are basically planning the cap table as if the transaction has occurred. So in the legal world when we say cap table, we say that’s as if fully diluted basis. So, fully diluted which you have heard obviously, fully diluted as converted basis means every transaction, everything that could have occurred has been accounted for in the cap table. All your stock options, all your warrants, convertible notes, whatever it is that you set out, stock options et cetera has been sort of taken into account, it is cap table ESOP, that’s the fully diluted. The pro forma is basically only what the cap table would like post-transaction.

Rajinder: Quick follow up on this one. So in the US you have common practice of rounds getting structured as SAFE notes whereas in india it tends to be largely priced rounds, how does that affect the cap table?

Shantanu: No, that’s a very good point. i think one of the things in the US is that rounds ten to happen very quickly in the US. Part of that i think is obviously the ecosystem is very mature. The other is the legal documents have been slimmed down. Typically it’s three basic instruments you find in the US convertible notes, SAFE, and there something called KiSS which is kind almost like SAFE. SAFE became popular last 3 or 4 years. You didn’t hear about that in the famous incubators or accelerators in the US.

it’s also almost geographic that convertibles are actually more popular in the East Coast and the SAFEs are more popular in the West Coast that could be a little bit broader, you don’t see that many SAFEs actually outside Silicon Valley.

But you can still have cap table with convertible note, the issue is that when you do the cap table, you will not be able to necessarily determine the number of shares that is going to be attributed to that SAFE or convertible notes simply because usually what happens the purpose of the SAFE convertible note is actually what we call kick the can down the road. You are basically pushing off that valuation discussion for other day.

And the reason why actually it’s probably good for both parties in some way is because it’s hard to determine the valuation at the very early stages of a company. What is the valuation determined on? it’s determined on several factors. There are creditors, total addressable market, customer base et cetera, and product.

But generally it is very hard to determine that valuation. Therefore, the practice at least in the US typically has been to kick the can down the road. i know india is probably less common and typically there is more resistance on pure valuations sort of where handing down a certain amount. i am not sure - maybe it’s a cultural thing also that people want to know exactly what they are getting. i mean there is some element of what’s behind the door in a convertible note or SAFE.

There are ways that investor can protect themselves like for example you can have the valuation app for example that basically the valuation will basically be capped at a certain level and if it goes above that the investor actually benefits. So those are some things we do see in the Valley that you can have taking the two that basically, okay, we won’t have the valuation, we will cap it at a certain amount and that’s the benefit from having valuation cap on that front.

You have discount ratio. So you have discount to the convertible note, typically 10 to 30% that’s what you typically see just so that the risk reward that an investors invested in the company and therefore against this discount.

Rajinder: technically how this three instruments are different?

Shantanu: No, they are actually legally also. And again, all this is more in the US context because they don’t necessarily translate entirely into india although there are some elements that we have for example in india we call it convertible note, india actually call it debenture . And also then you have for example an indian company and you are taking money from overseas, so this is what it essentially means and essentially that’s what it is. The problem is that you are an indian company taking debt from foreign party. The issue is can you pay that debt back and the answer is no. And so the actual convertible has to be a fully convertible note into india. So you must structure it as a fully convertible note. That’s one slight nuanced when you are working with foreign investors that they have to be a structured convertible note. Otherwise there are problems with that structure.

if you are dealing with a domestic investor, i think there is a lot of flexibility on structure and then essentially different from say KiSS because it is a debt issuance. They say promise to pay back money at a certain point of time as maturity date hopefully one to two years or 30 days, also and there will be a threshold - something that will cause that convertible note to convert to equity, typically the next round of financing and there will be some kind of next round of financing

The second will be some kind of acquisition offer. For example, suddenly you got an acquisition offer then the note will convert. The third would be maturity event. Typically nobody wants to get their money back in the sense that you are investing in these companies for equity.

This can be distinguished from a SAFE which is simple agreement for future equity. So [indiscernible] debt, it’s a way to basically it’s agreement saying that i am going to give you money it’s going to be an agreement that will allow me an equity in the company.

in the same way the sort of brick hole or loophole is what if company never raises money, what happens? Atleast in the note you can call and get the your money back. in the SAFE that is sort of brick hole in the SAFE, that investors are looking for conversion and they are usually experienced angel investors who are investing and really looking to get money paid back in the same way, but that’s sort of the technical legal definition of what is really sort of almost debt instrument, here i have got some SAFE’s and then one of the VCs here has authorized that. i don’t know if you have seen this in your market.

Rajinder: Many people here will be hopefully preparing a cap table very soon as they build their company. What should the ideal cap table have? Like what are some of the basic mistakes to avoid?

Shantanu: The biggest example in the world if any of you saw the movie The Social Contract, and that movie was about a promise where a certain amount of equity in Facebook.

So even in the US in a sophisticated market where you create a very large - one of the largest companies in the world this sort of thing happens all the time. So, it’s not unheard of basically there are promises made and company come out of the woodwork later on saying, hey, you promised me and i get 2% in the company. i am like come back for my 2% where is it? So you do see this.

So it’s very important that all these things be documented. So i think that is one of the key sort of elements mistake that it’s all documented. And it’s hard because initially everybody’s friends or family members or investors or whatever, but there is a some amount of formality because future investors like Matrix they don’t want surprise.

Rajinder:What are big mistakes other than not documenting things?

Shantanu: So i was talking more at a very early stage. As you get into later and later rounds, i mean for example i have done series F now. And series F typically indian - north of 100 – 200 million dollar. So all these factors become compounded because you have all the way to series F. You have A, B, E, F. plus you have a seed round before that, so then your spreadsheet or Excel sheet or cap table becomes very complex. And you have layers upon layers of scenarios and basically preferences.

Then you also have what they call participating preferred and we see that in india as well?

Rajinder: We see it but we don’t believe in it. We don’t ask for it.

Shantanu: Got it. So, it is something you see maybe in some other market. But certainly in US market you actually see it. But it’s actually we have a preferred VC will get their 1x or whatever or say 25 million, they will get their $5 million or 1x on the common stocker for equity share in india, and then they will participate again on a pro rata basis. i see this a lot where i think a lot of founder don’t necessarily understand this context. .

Shantanu: Yeah, go ahead please.

Question: Shantanu, this is Himanshu. So, what i heard from you what cap table means, it sounded more mysterious than a simple stable. So, if i make a let’s say very naïve assumption that for a given situation, there is a possibility of different interpretations and a possibility of more than one cap tables for consideration,

Shantanu: i would say the answer is yes and no. You actually don’t want an actual cap table. But the thing is you can have some version of [indiscernible] cap table. What i mean by that is [indiscernible] different scenarios based on a different valuation for example, right. So for example, on a different valuation, the cap table might be slightly different in terms of percentages or if your ESOP at a certain level versus another level. Or if one founder leaves the company for example. So you can have different sort of [indiscernible] types of cap table based on particular scenarios, but at the time eventually what one really find in cap table that is the actual reality of the company..

Rajinder: if i would just break it down on in [indiscernible] template for you. There are big variables that change the cap table. One is of course is your pre-money valuation.. Two is who are the investors and how much are they investing. Then three is what does the cap table look like today because what most people forget is they just focus on the first two. What they forget is the third part. So you don’t know actually hold the number of shares that are outstanding as on day because your price of share and everything gets divided from there

So i have seen multiple examples of situations where founders have said that oh, we have 1 lakh shares outstanding and that’s what's issued out for founders and carved out something for ESOP. And then we, later on, did some basic diligence, we realized that it wasn’t 1 lakh, it’s actually 1,15,000 We actually issued out the shares to one other co-founder, but he has left the company. And there are all sort of issues that we then need to take into account.

Shantanu: Just one more thing on the cap table i want to talk about is that i see a lot of recap - what i mean by that is that companies you have essentially flip or move their jurisdiction corporation to various places. Actually as an increased trend for certain types of companies for example, certain companies [indiscernible] now, certain B2B stocks [indiscernible] area for investors and a lot of those companies are [indiscernible] US in Delaware in particular. So we often get calls about an indian company which is incorporated in india and now because they are planning [indiscernible] be incorporated in US in particular, so then how do we recreate that cap table? So for example the math is slightly different in india versus 1 lakh shares in US needed to study different models under that. And there are RBi questions in terms of how to recreate the cap table particularly for india tax residents how do we get them share in the US company. So there is some complexity around flipping that structure.

And just in general if somebody is trying to flip the structure, it’s better to do early than later because the longer you delay it then it’s almost impossible to flip it.

Question: Hi, i just had a question for both you. For companies which are moving beyond seed towards series A, [indiscernible] any advice you have of how that can be designed so that when the series A guy comes in or when folks like yourself come in and look at it with their magnifying glass,

Rajinder: Yeah, i would first and foremost create ESOP pool.

i think the other thing is you need to clear on who has been allotted much because the one big thing that VCs would care about is how much of that pool is already been allotted or verbally at least promised. You may not have a formal ESOP policy that’s already laid out and people may not have been in any formal communication. But if there has been some commitment made, then you – key employees then you do want it clearly laid out because what investors care about is what is the unallocated pool because that’s the pool that has [indiscernible] for future key employees to be part of this company’s journey.

And i think the third thing is that if things have been setup it should have ideally gone by a lawyer because many people actually pick up documents and try and modify them.. You do want to work with a lawyer to make sure that you have drafted the policy right. And some people do it by trust. Some people do it by just a pool. [indiscernible] some of the differences,

Shantanu: i think the most important part of that really is that part of the promise that’s really what i see is typically once it’s all set, everybody has stock option, after things are done. it’s usually more complex and gets more contentious before that.

So you are trying to recruit five engineers. And you are going to tell each one you are getting an X and Y, right?

Again it’s typically better everyone has a raw number as opposed to a percentage because that’s not the best practice.

Rajinder: Another simple best practice at an early stage is, the best way to communicate with people who are joining the company is more in terms of the multiple of their compensation because most people think of it terms of A) i am being paid X in CTC than what is it in ESOP.

Now i see a lot of people saying, hey, you can give X percentage of the company or you can give Y shares. Of course, the employee is going to ask what is the value of these shares. And i find that easiest way to communicate that is what is that relative to your CTC. At an early stage, one is very generous but not [indiscernible]. As companies kind of throw generally [indiscernible] because everyone is trying to calculate how much of multiple this i can really earn over a period of time. So probably [indiscernible] 20 lakhs of equity at a series A stage, [indiscernible] company goes on to become 100x where it is today assuming that the price of share doesn’t go 100x probably because [indiscernible] half of that and that employee stands to make 50x on value of the ESOP that they have been promised upfront.

So that’s a huge number and so it’s always more important when you are communicating with people joining company that A) We are getting X lakhs of worth of equity and the future opportunity is this that the company achieves more in terms of growth and valuation.

Question: Hi, thanks. Both of you again, this is Akshat Birla. i am running Fintech company called Finovate Capital. One question which we grapple with is how do you incentive advisors? Because how do you create an advisory board in addition to the ESOP board without creating a tax liability which is immediately applicable to these guys because they are not employees of the company.

Shantanu: That’s a very good question. in US probably it’s a little bit easier because you can allocate the shares. And i have seen that [indiscernible] discussion very early on then they are almost quasi co-founders because you can actually issue them very low priced stock for example, so that they can buy the shares at a low price. if they come in later, then the price [indiscernible] because now the valuation has gone up and you can’t really issue [indiscernible] stock. So this is really the other way, sometime if ESOP or US people have what they call phantom ESOPs and basically a market, but basically would be phantom in the sense that they will get paid out in cash.

Rajinder: Thank you everyone. Shantanu, thank you questions that you had.