Notes

Pros and Cons of Cap and Trade Valuations
Cap tables are a key component of every private equity fund. A cap table helps you understand your firm's capital structure, and it assists you and other investors in assessing who owns what. Managing this cap table effectively is an important function to establish in a seed-stage company, yet many new entrepreneurs often neglect it. When we refer to "managing" a cap table, we are not talking simply about paying a CFO to manage it, or hiring an investment banking firm to do so. We are talking about making sure that the appropriate amounts of cash are invested in the various aspects of your business.

Many angel investors focus primarily on the need for funding to grow their portfolio through acquisitions or investments in your startup . If you are starting a company from scratch, one of the biggest challenges will be raising venture capital, which will require you to have strong cap table management. As a startup, you have few resources that are not immediately accessible, such as angel investors and/or your own employees. These resources can quickly become strained if your capital needs grow unexpectedly, as they did for MySpace, Enron, and several other well known companies.

In the early days of your business, you will likely face financing problems and a cap table will be an important tool for you to address these issues. In the earliest days, allocating funds to various ventures can be a time-consuming exercise that can also result in poor optics. While this can have a negative impact, it is important to ensure that these issues are addressed and are not overlooked in the early years. The biggest risk of ignoring a cap table during the early days of your business is that your investors and employees will not be properly capitalized to take advantage of the opportunities that arise. While this may seem like a risk you are willing to take at the time, missing this opportunity will ultimately cost you money in the form of lost equity and employee attrition.

When the funding round is complete and the business is ready to raise equity, the cap table management will help you to determine how much equity should be raised and at what price. This will help you to maximize your return on equity and keep your exit strategy in place. For some venture capital firms, exit strategy is critical to the success of the investment round. If they cannot sell enough of your equity for your exit in a timely manner, your founders and employees could face a lawsuit. Therefore, it is important to ensure that the valuation of the enterprise is based on accurate assumptions regarding the market value of the business and if financing is needed to continue the venture.

The process of equity compensation also involves the use of a cap table. A cap table is used to offset potential losses due to underpricing the equity. Equity compensation is a key part of the negotiation of employee shares. For example, an employee might receive stock options after graduating from college and entering the workforce. If the company does not realize a profit from the options, the employee will lose equity.

The convertible notes are another type of cap table that provides a method to finance short-term debt. Convertible notes are used to finance acquisition or merger activity. For example, a merchant could purchase property with the capitalization table that converts into notes upon the sale of the property. This allows the merchant to pay taxes on the loan even while waiting to receive the proceeds from the sale of the property. As a result, capitalization tables can help a business obtain cash during a period of financial difficulty. The convertible notes that are created by a cap table are only realized if the company does not incur any negative cash flow during the year the note is held.

The convertible notes scenario modeling strategies also allow companies to exercise stock option purchases in an effort to increase liquidity. In this scenario, the options purchased are typically underpriced compared to the overall stock price to give the option holders the opportunity to exercise for a greater value than what they would be afforded under the existing terms. The potential upside in exercising the options often results in the option holders exercising their rights to acquire additional shares of stock from the company. In this manner, the option trading strategy can produce positive cash flow situations for a company while concurrently minimizing the potential downside in the event that the company's stock price does not appreciate as expected.

Cap and trade table management strategies are designed to maximize the value of the equity plan by providing the data necessary for an accurate valuation of the plan. Although a company may incur losses from time to time, these losses are generally offset by gains realized on the equity plan and are usually small in comparison to the potential gains if the company were able to realize its full market valuation of the plan. Cap and trade valuation is a highly effective method of financial reporting, particularly in scenarios where the reporting is for an initial public offering of securities or for modifications to the plan that do not change the fundamental nature of the underlying assets and liabilities.
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