Capitalization of a Startup 101

The definition of startup capitalization. Debt funding vs equity funding. The contents of a cap table and ways of managing it. Authorized shares vs issued shares. Dilution of stakeholding

Startup capitalization is a vital parameter for investors and entrepreneurs. From this article, you’ll get to know how to capitalize a business that is just getting started.

What is capitalization and why do startups need it?

To be able to launch their operations, startups need cash. They use this money to purchase or rent real estate, vehicles, and other assets; hire staff members and buy inventory; put aside a reserve fund.

To convince investors to support your company, you should create a compelling business plan where you’ll explain the following aspects.

  • Your startup’s goals
  • Your target market
  • The reasons why consumers will be eager to buy your goods or services
  • The amount of funds that you need
  • The approximate date when your startup will start bringing revenue
  • The expected amount of revenue

Your potential investors and people or organizations that lend funds to you want to be sure you’ll pay their money back. To boost the accuracy of your forecasts, you should model out several financial scenarios.

Two types of capitalization

To capitalize your startup, you can resort to either debt or equity funding. The former enables you to keep full control over your business. But you should be ready to pay monthly installments, debt covenants, and interest expenses if you take a bank loan. If you prefer debt funding, the most challenging task will be to convince the bank to give you a loan. Banking institutions are not too enthusiastic about supporting companies that might shut down even before they begin to generate profit. To boost the odds of getting your loan application approved, you can offer your house or car as collateral. Alternatively, you can borrow money from friends and relatives. You should pitch your business idea to them as if they were professional investors.

Equity funding means that you allow third parties to exercise control over your company. You won’t need to pay back the debt in monthly installments but you’ll need to give investors shares of your business. If the investors are experts in your industry, they might provide you with knowledge and contacts. Generally, investors don’t ask founders to share a part of your profit with them but they might do so on rare occasions.

It might be wise to combine the two types of funding. To find the optimal balance between debt and equity, you should consult your business mentors as well as tax and accounting professionals.

A cap table: what is it and why is it important?

A cap table is a document that reveals

  • how much stock a business has already issued,
  • which part of the stock is currently available,
  • identities of all stakeholders,
  • the share of each stakeholder.

As the business progresses through its funding rounds, this information gets updated when any of the following events occur.

  1. Convertible notes are converted to stock
  2. Stock options are exercised
  3. New investors are buying in

When a potential investor looks at the cap table, they can assess both the earlier development of the startup and its future potential. They can see who of the stakeholders has the most influence over the business. Plus, the cap table allows investors to assess the impact of fundraising rounds and future share issues.

Apart from scrutinizing the cap table, investors will assess the professionalism of the founders and the overall market situation. Startup funding belongs to the category of high-risk investment. The past performance of the founding team can’t guarantee their future performance. Investors will be more likely to support companies that have a solid exit strategy. They will take into account multiple factors but the cap table will be one of the most crucial ones.

How to manage a cap table

When a startup is just taking off, its cap table is concise and easy to read. Over time, the business will attract a large investor pool and its cap table will become very complex. Potential investors will be looking for exhaustive information about the businesses.

To manage their cap tables, startup founders can try these options.

  • Store the data in Excel spreadsheets — it makes sense at an early stage of the company’s development.
  • Install dedicated software — unlike Excel, such apps are not free, so you should get one only after your business begins to generate profit.
  • Find lawyers or accounting firms who can manage cap tables for their clients.

Only one professional should be in charge of updating the cap table. They should act as a single source of truth and prevent misinterpretations. When appointing this professional, the founders should tell them which information they can reveal to each group of individuals.

  • Founders should get access to all data.
  • Employees might get access only to the data that is relevant to their positions.
  • Investors should get to know only those facts that can positively impact their decisions to support the company.

When arranging the information in the cap table, people in charge should also make it user-friendly for the HR department. This document features a transparent record of the equity structure and the potential value of employee stock options. It reveals the payment amounts and priorities to all stockholders in a liquidity event. The cap table helps founders and their HR teams decide which specialists to hire and on which conditions.

Authorized shares vs issued shares

When an entrepreneur launches a business, they decide that their startup will have a certain number of shares. Most startups offer 10 million authorized shares because that’s an industry tradition. Your business can have more or fewer shares.

Holders keep a part of authorized shares for themselves. They need this stock to control the business. Such shares are called issued ones or outstanding ones.

The part of authorized shares that doesn’t belong to founders will be distributed among the employees and future investors. Employees should receive their shares to be motivated in the business development. Authorized shares that founders will distribute among other people will enable the company to grow, develop and generate profit.

Dilution of shareholding

The term dilution means the share of founders will be decreasing as the startup develops. The part of the startup that the founder controls is determined by how many issued shares they own. Let’s explain it using an example of a fictional startup.

10 million authorized shares were created by founders, of which 8 million shares were issued, 2 million shares were held back for future investment. One of the founders got 3.6 million issued shares initially which enabled them to control 45% of the business. In a funding round, 2 million authorized shares were distributed among investors. The founder’s stake got diluted and became 36%. The company authorized and issued 2 million shares in addition to the initial 10 million. The percentage ownership of the founder dropped to 30% even though they didn’t sell a single share of their 3.6 million

To authorize additional shares, the company needs to hold a meeting where the majority of its stakeholders and its board of directors should vote. The startup might need additional authorized shares to allocate stock options to attract key staff or to seek additional funding. Over time, the part of the company that is controlled by the founder will get further diluted.

Essential terminology of a startup’s capitalization

To be able to analyze a startup’s capitalization, you should get to know the basic terms.

  • Pre-money valuation — how much a startup costs before its first funding round or before it attracts any other type of investment.
  • Post-money valuation — how much a startup costs after attracting investment. To calculate this indicator, you should add the amount of the investment to the pre-money valuation of the business.
  • Stock price — how much one share of the business costs. To calculate this indicator, you should divide the post-money valuation by the number of fully diluted shares.
  • Preferred stock — shares with special rights that enable their holders to exercise a liquidation preference. If a liquidation takes place, holders of preferred stock will be paid before holders of common stock.
  • Common stock — this type of share grants investors an ownership stake in the company. However, if an investor supports a startup, they might prefer to purchase preferred stock and leave common stock to founders. All publicly listed businesses offer common stock.
  • Participating preferred — if a liquidity event takes place, holders of preferred stock will receive their liquidation preference at the agreed multiple of the original purchase price. They can also benefit from “double dipping” — that is, participating in the deal as common shareholders.
  • Convertible note — it’s a debt that will convert to equity when the lender will be repaid in company stock
  • Simple agreement for future equity — this term is often replaced by the SAFE acronym. It resembles a convertible note but doesn’t involve any debt. An investor supports a startup with cash and gets the right to convert to stock at an agreed price when a specific event occurs.
  • Stock options — it’s a right to buy stock at a predetermined price. At the moment of the purchase, the current stock price can’t affect stock options.

Plus, you might need to know the term “Waterfall analysis.” To estimate the return for stockholders in the case of a liquidity event, waterfall analysis can be applied to the cap table. Sometimes, the valuation of stock might remain uncertain until the sale begins. Waterfall analysis enables you to detect powerful trigger points and thresholds in the valuation as well as foresee the impact that it can have on all stockholders. This method recognizes the rights and interests of the various types of individuals (such as lenders, investors and stockholders).

In conclusion

The term “capitalization” denotes the money that founders need to get the business going. They can choose from debt or equity capital. All the information about a startup’s capital is stored in a document called a cap table. Investors will scrutinize the cap table before deciding whether to support the business or not.

Incubator director of the Admitad Projects startup studio