The capital table is a reflection of the shareholding pattern of a company, shareholder names, percentage of shareholding. This shareholding should ideally reflect the voting percentage in the company. But does it? What if the ESOP percentage has to be included while there is no voting on ESOP?
Founders should also consider the number of people on the capital table, though the maximum number in a private limited is 200, for various reasons including logistics of execution of documents, distribution of the annual accounts & annual report etc.
In this post, we have captured some of the key aspects to be considered while structuring the capital table.
At the time of Incorporation: It may be noted that the subscription of shares at the time of incorporation will be at face value and cannot be issued at a premium. The initial subscribers are usually the founders themselves.
The shareholding pattern amongst the founders is a function of many factors, such as roles and responsibilities and what each of them would bring to the table, whether investment is in cash or in terms of performance and service, for example, as a technical expert or a marketing expert. It certainly helps in decision making if one of the founders have majority shareholding. It is highly recommended that the founders enter into a founders’ agreement wherein the number of shares, percentage shareholding, future investment, vesting schedule, if any; roles and responsibilities of each founder, treatment of shares upon termination, etc. This would help in setting expectations as well as helpful in easing the founder terminations / resignations.
Employees Stock Option Pool (“ESOP”): A great team is instrumental and vital to the growth of an early stage company. However, the company may not have the finances to compensate with market salary to its employees at early stages (unless well funded). Thus, issuing stock options becomes very attractive – not only as compensation mechanism but also as building ownership and responsibility in the company. Stock options are notional unless they are exercised and shares are allotted. They represent a right to purchase a specified number of shares at a specific (exercise) price. When an employee exercises the Options and issued shares, then they became part owners in the company and can also sell the shares. Stock Options cannot be transferred or sold. Please see our previous post on Ten Frequently Asked Questions on Exercising Employee Stock Options in Private Limited Companies for more details in this regard.
Though Stock Options are not shares yet, it still forms a part of the capital table. External investments into the company, be it angel or institutional investment, are on a fully diluted basis. Ie. a shareholding pattern, as if all the outstanding share allotments regardless of vesting, assuming all stock options are converted, assuming all convertible securities are converted into common shares. Hence, Stock Options also form part of the capital table. In such a scenario, the percentage captured in the cap table is not necessarily the percentage of voting.
At the time of Investment: Whenever new investors subscribe to the shares of the company, the capital table undergoes a change. All the earlier shareholders’ percentage holding dilute, while the number of shares that they hold remains. If ESOP is set aside before the new investors coming in, then ESOP percentage dilutes, while the number of options set aside, remain the same.
Issuance to Advisors: Issuance of shares has to be at fair market value. Many a time, it is convenient for the founders to transfer their shares to the advisors. However, tax impact has to be evaluated for such transfers.
In India, we have different kinds of shares:
Equity share capital (common stock): (i) with voting (ii) with differential rights, such as dividend or voting. Founders typically have equity shares. ESOP is also typically granted as equity share class.
Preference share capital, which carry a preferential right over the equity shares to be paid dividend and a preference for repayment of capital in case of winding up. Investors typically have preference shares.
Preference shares can be:
Cumulative preference shares, which means that the holders are entitled to receive dividend even when a company does not make (adequate) profit, in which case the dividend is accumulated and paid when the company does have sufficient profits.
In Non-cumulative preference shares, the holders get the dividend only when a company makes sufficient profits, else the dividend lapses and cannot be carried forward.
Participating preference shares, means that the holders are eligible to receive surplus profits or dividends in addition to being entitled to their fixed dividend.
In Non-participating preference shares, the dividend paid is only to the extent of the agreed fixed dividend.
Convertible preference shares are those that are converted into equity within the maximum period of 20 years. Non-convertible preferences are those that do not get converted into equity shares.
Redeemable preference shares or optionally redeemable preference shares are those that have to be paid back within the maximum period of 20 years. We don’t have irredeemable preference shares.
The other form of investment is as debentures, which is primarily a debt. But the debt can convert into shares through the issuance of Compulsorily Convertible Debentures (CCD). You can read our post on CCD on the nuances related to its issuance. https://novojuris.com/2018/03/21/nuances-associated-with-issuance-of-compulsorily-convertible-debentures/
Investors also invest through CCD, especially when the valuation of the company is not clear. Here’s how it is done https://novojuris.com/2015/12/21/raising-of-funds-through-compulsorily-convertible-debentures/
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