This post was originally produced for Forbes.
Social entrepreneurs can be parsed along a variety of different axes. One of those is whether the social entrepreneur comes primarily from a business or entrepreneurship background or an impact background without much business experience. This piece is written as a primer on capitalization tables, or cap tables, for those without much business or entrepreneurship experience.
For this piece, I’m drawing principally on my experience running an FINRA-registered boutique investment banking firm that worked primarily with small and midsize companies.
The cap table is the list of owners and their respective stakes in a business and their respective ownership stakes. Generally, entrepreneurs and investors agree that a simple cap table is a better cap table. The fewer the investors the better. When it comes time to make key decisions that require approval from shareholders, the fewer signatures required, the better.
That said, the clutter in a cap table usually comes from a simple need: more money. Investors bring the money entrepreneurs often can’t succeed without.
To optimize your cap table, you will want to be strategic. Start by raising money in rounds rather than in one-off lumps. Rather than negotiate a deal with your uncle one day and a separate deal with your aunt on another, organize a round of friends and family financing and give everyone the same terms. Another key to strategic capital is to take as much capital as you can in each round, so that each will last as long as possible.
At this point, you may be thinking how many rounds will there be? If I sell 20 percent of my company in each of five rounds, does that leave any for me? Isn’t five times 20 percent equal to 100 percent of my company?
It is difficult to know in advance how many rounds of capital will be required, but first time entrepreneurs are often surprised to learn that the big rounds of capital often come after—rather than before—the company becomes profitable. It takes money to grow. When the company is growing, the value is growing. That growth in value effectively makes room for more capital.
Here’s how it works.
For simplicity, let’s assume that you are a single founder that owns 100 percent of the common stock of the company, let’s call it Startup Co. Each time you raise money, you’ll likely issue new preferred shares that will give special rights to the investors, including most importantly the right to get their money out before you get any money out when the business is sold or liquidated. To be clear, you don’t sell any of your common stock. You keep that and issue new preferred shares to the investors.
Sometimes convertible debt structures are used in early rounds to provide similar protections to preferred stock with simpler legal formalities.
Let’s say you do a friends and family round that is what it sounds like, a round of financing from your friends and family. Sometimes these rounds are said to include friends, family and fools as they tend to be so risky. It isn’t really foolishness to invest, especially in social ventures; rather, it is altruism. People want to help you succeed, especially if you have a mission in mind.
If you raise $50,000 and sell a number of shares equal to 20 percent of the post-transaction total, that is 20 percent of the business, you’ve effectively valued the company at $250,000.
That valuation is said to be the “post money” valuation. It is determined by dividing the investment by the percent of ownership, or $50,000/.2. (That intimidating looking math is easier if you remember that dividing by .2 is the same as multiplying by five.) That implies that just before the investment was made, your business was worth $200,000. The money could only have added $50,000 of value. That $200,000 is said to be the “pre-money” value of the business.
So, as an entrepreneur, your Startup Co, which may be little more than an idea when you raise $50,000 from friends and family, is now worth $250,000 and your share of that is $200,000.
That money won’t last long, but if you are successful in making real progress with it, perhaps by developing a successful prototype or even a marketable “minimum viable product” or MVP as it is called in lean entrepreneurship circles, you may be able to raise a formal seed round of capital of say $500,000. Let’s assume once again that you sell 20 percent of the company.
That investment implies a post-money valuation of $2.5 million and a pre-money valuation of $2 million, ten times the old value. But, there are more shares outstanding. You don’t own the whole $2 million like you owned the $200,000 before the friends and family round. Your friends and family own shares, too. Even so, the value of the shares will have increased eight-fold since the last round. Your founders shares are now worth $1.6 million and your friends and family investors now find their $50,000 investment to be worth $400,000. Not bad.
Keep in mind, this is easy to do on a spreadsheet. The challenge is to build a company that achieves these milestones.
The next round would traditionally be called an “A-round” referring to the Series A Preferred Stock issued by the big venture capital firms that make these investments. To keep our math simple, let’s assume that the A-Round is $5 million and that once again Startup Co sells 20 percent of the business. That would value the business at $25 million, implying a $20 million pre-money valuation. Even after three rounds of capital, the founder still owns more than 50 percent of the business and theoretically owns stock worth $12.8 million.
A follow-on round of venture capital would typically be called the “B-round” and could be as much as $50 million, implying a post-money valuation for Startup Co of $250 million and a $200 million pre-money valuation. Your founder’s shares would be worth $102.4 million at this point.
If all goes well from there, an IPO could be in the offing. An IPO is an initial public offering. Rather than sell shares to one investor or a small, cooperating group, the shares are sold by an investment banking firm to the public. If you could raise $500 million in your IPO, that would value the business at $2.5 billion. Your founder’s stake would be worth $819.2 million even though you have sold 20 percent of the company five times. And those friends who put up $50,000 in the first round, their shares would be worth $204.8 million.
In the IPO, all of the preferred shareholders are typically required to convert their shares to common, just like the founder and just like the shares the public owns. Even in the IPO, however, it is difficult for the founder to sell shares. Usually, the founder will be required to wait until the company has been public for at least six month and perhaps longer before being allowed by the investment bankers, the lawyers, the market, the board of directors and everyone else with a say to sell their shares. Until then, the eye-popping valuation numbers are really just theoretical.
This hypothetical example is intended to help you see how raising money is a fundamental part of creating value in your enterprise. Of course, if your business fails to achieve milestones and runs out of money, all bets are off. Founders commonly walk away with nothing even after raising substantial rounds of venture capital.
The impact investing market focusing on investments in social enterprises is still developing. Many investors who do invest in impact still seek market rates of return on a risk-adjusted basis. These are still early days, but this model should at least help you to see how you can sell 20 percent of your business five times and still own enough of it to keep you motivated.