Every capitalization table (cap table) problem stems from two basic principles: lack of institutional control and excessive versions. Having to request your cap table from a law firm is a barrier to consistent and accurate updates. And once you have made the changes, it can be difficult to remember and communicate which version is the most up to date.
Here are the 10 most common cap table errors we see at eShares.
1. Dates that don’t agree.
The date a stakeholder exercises their options and the date their stock certificate is issued should be the same. In many cap tables, there is a delay between the two dates. Using software that allows you to issue shares electronically is one of the easiest fixes to this issue.
2. Not tracking transactions.
Many employees and investors have multiple option grants. When issuing shares it’s critical to track which option is being exercised to create which certificate. The option ID number needs to match the corresponding stock certificate. If it doesn’t, tracking transitions becomes extremely difficult. Additionally, this leads to improper exercises and potential tax consequences to the company and employee.
3. Wrong or varying entity names.
When dealing with stock certificates you have to be exact. Oftentimes cap tables use abbreviated or incorrect names for the same company. For example, one cap table we saw had a main investor fund entered as Mary Stuart and as Mary C. Stuart. Another variation using both ABC Ventures and ABC Ventures Fund. Shortened titles and varying forms of the same entity that do not match the company’s legal name can cause confusion and can cause you to have to cancel or replace mislabeled stock certificates.
4. Not asking your legal counsel when you have questions.
Thanks to new, intuitive equity management tools, equity admins can make a lot more equity changes on their own without fear of messing up. But, when it comes to complicated changes, like ISO to NSO conversions, equity buybacks, and more, it’s worth spending the money to consult your legal counsel.
5. Not tracking terminations and exercise windows.
When an employee leaves the company, many actions are put in motion. These all need to be managed and tracked. In unmanaged cap tables, employees could exercise options outside of their permitted window. They could also purchase more shares than what they have vested. We see this happen all the time. If an employee early exercised their options then the repurchasing of unvested shares by the company needs to be done clearly, efficiently and with proper tracking.
6. Founders not understanding liquidation preferences.
This is a big one. Founders could be inadvertently increasing their dilution without realizing it. All it takes is one cumulative dividend or participating preferred to really dilute the common shareholders. The cap tables that people build out on their own almost always only shows number of shares, not fully diluted percent ownership, so it is easy to lose track.
7. Not accounting for option expenses when updating their cap table (no pun intended).
Many founders don’t understand that there is an expense associated with every option that is granted that hits their balance sheet. Careful consideration should be made on expense implications of new awards as well as modifying old awards. ASC 718, the guidelines that dictate expense methodologies for most awards, are tough, but important to follow and track.
8. Issue options without a defensible Fair Market Value (409A).
A 409A valuation will set the Fair Market Value of your shares. Some founders make the mistake of issuing options without a 409A or out of their 409A safe harbor period. This can often lead to major tax implications for both the company and the employees who received these awards.
9. Forgetting Rule 701 and Form 3921.
If you are a larger company and you pass the Rule 701 thresholds, you need to make the proper Rule 701 disclosures before equity awards. Many companies don’t even realize this is a requirement until after they have passed the threshold. Form 3921 for ISO option grant exercises needs to be filed for the calendar year in which those exercises occur.
10. When transitioning to a cap table management software, forgetting to track which certificates have already been granted on paper.
Without tracking paper certificates, the same stock could be issued twice accidentally. Companies and law firms forget what’s been sent out, have to make corrections and end up Fedexing certificates back and forth. Then they lose the information by failing to track it.
Written for Entrepreneurs’ Organization (EO) by Jesse Klein, content marketing manager at eShares Inc. EO is the only gobal network exclusively for entrepreneurs. Learn more and apply today.
Categories: Best Practices FINANCES LEADERSHIP