Understanding the Basics of Cap Table Math in Startups

Capitalization tables, colloquially known as cap tables, are the foundational ledgers that illustrate a startup’s ownership structure and equity distribution. They serve not only as a historical record but also as a predictive tool for future equity changes. Cap tables are invaluable because they encapsulate the potential impact of financial decisions on equity dilution and ownership shifts.

A well-structured cap table will outline all varieties of securities—including stocks, options, warrants and convertible instruments—while distinctly presenting each equity holder’s stake. This comprehensive account ensures that all parties understand the equity implications of financial events, such as investments, stock issuances or conversions of debt to equity.

The key to grasping cap table math lies in understanding how pre-money and post-money valuation and capitalization interact. Pre-money capitalization refers to the total number of a company’s fully diluted capitalization immediately prior to a financing. Pre-money valuation is the market value of these shares at that point. Conversely, post-money capitalization refers to a company’s fully diluted capitalization immediately after a financing (i.e., a company’s pre-money capitalization plus the shares issued in the financing). Post-money valuation is then the market value of the company based on this updated capitalization.

It’s crucial for startups to appreciate that cap table dynamics are not static. They evolve with each funding round and strategic financial decision, affecting not just the present but also charting a course for the company’s financial future.

I. 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% 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%

This starting point is crucial for mapping the evolution of the company’s equity landscape. As XYZ Tech grows, its cap table will become more complex with the addition of new shareholders, such as employees granted stock options and investors providing capital in exchange for equity.
 
It is essential to maintain this document with precision, as it will serve as a historical record and a predictive model for future changes in ownership. Regular updates to the cap table will reflect additional distributions of shares, conversions and other equity-related events, thus providing a clear and current view of the startup’s financial structure.

II. Raising Cash – Transforming the Cap Table
Before a company raises its first round of financing, it’s crucial that the founding team understands how this process will impact the company’s 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 capitalization table following a financing.

Example 1: Initial Capital Raise Impact on XYZ Tech’s Cap Table
Assume that Alice and Bob met 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., because 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 with the following process:
 

1. New Investor Ownership Percentage: The $1 million investment translates into a 6.25% ownership stake in XYZ Tech on a post-money basis ($1,000,000 investment/$16,000,000 post-money valuation).
2. Pre-Money Capitalization Ownership Percentage: Alice and Bob currently own 100% of the company. After the investment, their combined ownership will adjust to accommodate the new investor’s 6.25% ownership stake, leaving them with 93.75% of XYZ Tech post-money capitalization (100% - 6.25%).
3. Post-Money Capitalization Shares: Post-money capitalization can be calculated by dividing the pre-money capitalization by Alice and Bob’s remaining ownership percentage after the investment (i.e., the pre-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 the new investor receives, we multiply the new investor ownership percentage we calculated in Step 1 by the post-money capitalization calculated in Step 3 (6.25% X 1,066,667 = 66,667). [1]
5. Post-Money Cap Table: The final step is to update the cap table with the new share distribution:

 

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	$16,000,000	1,066,667	100.00%

 

III. Option Pool Increase and Convertible Notes

Example 2: Incorporating Convertible Notes and Employee Stock Option Pool (ESOP) Prior to Investment [2]
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% discount. For those unfamiliar, convertible notes are short-term debt that will usually convert into equity at the most favorable price per share derived from either at a valuation cap or at a discount during a company’s next equity financing. For this example, the notes covert using a discount rate.

Assume further that XYZ Tech is required to create an ESOP equal to 15% 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 determine the ownership percentages of the new investor, ESOP and the noteholders, then back into the share amounts, as follows:
 

1. New Investor Ownership Percentage: The new investor still receives a 6.25% ownership stake in the 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% 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 / 0.80 = $625,000) by the post-money valuation: ($625,000/$16,000,000 = 3.90625%).
4. Pre-Money Ownership Percentage: We calculate the pre-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% - 3.90625% = 74.84375%).

As in Example 1, to calculate the total post-money capitalization we divide the total pre-money capitalization by the remaining pre-money ownership percentage (1,000,000 / 0.7484375 = 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: 15% of total post-money capitalization = 0.15 * 1,336,117 = 200,418 shares.
• Noteholders Share Calculation: 3.90625% of total post-money capitalization = 0.0390625 * 1,336,117 = 52,192 shares.
• New Investor Share Calculation: 6.25% of total post-money capitalization = 0.0625 * 1,336,117 = 83,507 shares.

 

Shareholder	Value	Shares	Ownership
Alice and Bob	$11,975,000	1,000,000	74.84%
ESOP	2,400,000	200,418	15.00%
Noteholders	$625,000	52,192	3.906%
New Investor	$1,000,000	83,607	6.25%
Post-Money	$16,000,000	1,336,117	100.00%

 

IV. Simple Agreement for Future Equity (SAFE)

Another popular investment instrument that founders should understand is SAFE. A SAFE is an investment contract that is similar to a convertible note where investors provide capital to a startup in exchange for the right to convert their investment into equity at a later date, typically at a discount rate or based on a valuation cap. A key difference between SAFEs and convertible notes is that SAFEs are not debt, do not accrue interest and have no stated maturity date.

Example 3: Integrating a SAFE with a Valuation Cap and a Post-Money ESOP in XYZ Tech’s Cap Table
To illustrate the impact of a SAFE on a company’s cap table, let’s continue our analysis of XYZ Tech’s financing using the same scenario as before, except that XYZ Tech has a $500,000 post-money SAFE with a $10,000,000 valuation cap instead of a $500,000 post-money convertible note that converts using a 20% discount rate. As with any convertible security, the conversion mechanics for the SAFE are subject to the terms and conditions contained in the of the underlying agreement for the SAFE. Typically, a SAFE with a post-money valuation cap converts based on the applicable valuation cap immediately before the new money investment.

Using our example, this means the SAFE converts at the $10 million valuation cap rather using a discount rate, which means the SAFE holders’ ownership percentage immediately prior to the new investment is calculated by dividing the total value of the SAFE by the post-money valuation cap ($500,000 / $10,000,000 = 5.0%).

XYZ’s cap table immediately prior to the new investment is therefore:
 

Shareholder	Value	Shares	Ownership
Alice and Bob	$14,250,000	1,000,000	95.00%
SAFE Holders	$750,000	52,631	5.00%
Pre-Money	$15,000,000	1,052,631	100.00%

 
Now, the pre-money capitalization immediately prior to the new investment is 1,052,631 shares held by Alice, Bob and the SAFE holders. Using this information, we can calculate XYZ Tech’s post-money cap table as follows:

1. New Investor Ownership: The new investor’s $1 million investment equates to a 6.25% ownership stake in XYZ Tech ($1,000,000 / $16,000,000 = 6.25%).
2. ESOP Allocation Post-Investment: Following the investment and SAFE conversion, XYZ Tech allocates a 15% ESOP.
3. Pre-Money Ownership Percentage: Using the same methodology used in Examples 1 and 2, we calculate the pre-money ownership percentage by reducing Alice’s, Bob’s and the SAFE holders’ ownership by the percentages we calculated for the new investor, the SAFE holders and the ESOP (100% - 15.0% - 6.25% = 78.75%).
4. Calculating Total Post-Money Capitalization: Now, we divide the total pre-money capitalization by the remaining pre-money ownership percentage to calculate the post-money capitalization (1,052,631 / 78.75% = 1,336,675). Lastly, we update the cap table with the new share distribution by multiplying the ownership percentages calculated above for the new investor and the ESOP by post-money capitalization.

 

Shareholder	Value	Shares	Ownership
Alice, Bob and SAFE Holders	$12,600,000	1,052,631	78.75%
ESOP	$2,400,000	200,501	15.00%
New Investor	$1,000,000	83,542	6.25%
Post-Money	$16,000,000	1,336,675	100.00%

In this scenario, the inclusion of the SAFE with a valuation cap and the post-money ESOP significantly changes the equity distribution, illustrating the complex interplay of different investment instruments in startup financing.

VI. Timing of Option Pool Increase and Conversion of Notes or SAFEs
The timing of the option pool increase and conversion of outstanding notes or SAFEs—whether they occur before or after with an equity investment—can have significant implications for a startup’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 pre-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 ESOP and the noteholders in the company’s pre-money capitalization dilutes Alice and Bob’s ownership in XYZ Tech and the effective value of their investment by 18.91% (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 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 founders initially.

Example 4: Incorporating Convertible Notes and ESOP after the Investment
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 ESOP occurs after the investment, we calculate the shares issued to the new investor using the same calculation in Example 1.

1. New Investor Ownership: The new investor’s $1 million investment translates into a 6.25% 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 1,000,000 shares represent 93.75% of XYZ Tech’s outstanding equity and the shares allocated to the new investor is 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 (1,000,000 / 93.75%), which represents $16,000,000 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% [3] 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 the new investor and the noteholders are included with Alice and Bob in the pre-money capitalization. This means can calculate post-money capitalization by dividing 1,108,334 (1,066,667 + 41,667) by 85% (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	5.11278%
ESOP	$2,400,000	195,588	15.00%
Noteholders	$625,000	41,667	3.195%
Post-Money	$19,025,000	1,303,922	100.00%

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

VI. Sanity Check
Assuming that an ESOP increase and conversion of other securities occurs before an equity investment, here are two helpful calculations you can use to make sure your math is correct:

• Price Per Share: Dividing the investment by the number of shares issued to the new investor should equal the price per share calculated by dividing the total post-money valuation divided by post-money capitalization should equal the new money investment divided by shares issued to the new investor (e.g., using Example 2, $16M/1,336,117 = $1M/83,507 = $11.98). [4]
• Investor Ownership: The new investor shares divided by post-money capitalization should equal the new money investment divided by post-money valuation (e.g., 83,507/1,336,117 = $1M/$16M = 6.25%). [5]

VII. Summary
The exercise of constructing and analyzing a cap table, as demonstrated with XYZ Tech, is not just a mechanical process of crunching numbers—it’s an integral aspect of strategic financial planning for a startup. It allows founders and investors to visualize the impact of funding rounds on ownership and dilution, ensuring all parties have a transparent understanding of the value of their equity.

For XYZ Tech, the cap table math has revealed the delicate balance of interests between founders, employees, investors and SAFE/convertible noteholders. The post-money cap table, shaped by the investment terms and the conversion of SAFE/convertible notes, underscores the importance of considering all financial instruments and their conversion outcomes in the company’s equity structure.

The sanity check confirms the accuracy of our calculations and the fairness of the distribution, highlighting the investor’s proportionate share in alignment with the capital injected. It also reassures the founders that the post-money valuation reflects the true cost of capital raised and the dilutive impact it has on their ownership stake.

Founders must understand the impact the timing of an option pool or conversion of outstanding securities has on a company’s cap table and weigh the benefits of less dilution against the potential for a higher share price that could make the investment terms less attractive to new investors. Each strategy has trade-offs, and the optimal choice depends on the company’s leverage in the negotiation, the long-term vision of the founders and the expectations of current and future investors.

In summary, navigating the complexities of cap tables is a critical skill for startup founders. Understanding these dynamics is key to making informed decisions about equity and investment. At Pillsbury Winthrop Shaw Pittman, LLP, we guide startups through these challenging but exciting financial landscapes. Contact us to explore how we can support your startup’s journey.