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"Cap Table" is an apt description of today's real estate investing business. Today's hot topic is Cap Table, the hottest money making investment concept in our country today. "cap table" is a reference to the high commission payouts to investment bankers that take advantage of the minutae of the cap table. "The cap table" is a standard deviation of profits that is calculated each time a bank lends funds to a real estate project. In other words, it is a mathematical model that calculates the highest profit potential without taking into account the costs of borrowing funds.
Historically, startup and Wall Street insiders have manipulated the cap tables to earn large bonuses. In fact, during World War II there was a congressional investigation into the cap tables used by banking institutions. After the war, the government stepped in to regulate these predatory lending practices, but the V CSI laws were less stringent then they had been during the war. The current federal government continues to struggle with the V CSI problem.
As stated earlier, the basic purpose of Cap Table Math is to adjust the rate of return on investment by choosing investments based on projected future earnings instead of historical results. This problem is especially severe with REO equity financing where banks use the current owner equity to determine the amount that they should lend to an investor. Due to the potential biases of bank managers, the end result can be artificially low capital gains and equity levels. If this were not the case, then REO investors could obtain a higher rate of return on their investments that the actual historic performance of their company would justify.
To illustrate the seriousness of the current issue with cap table math, let's consider an example using publicly traded companies. Typically, these companies have long-term debt obligations and very little cash on hand. In order to capitalize on opportunities in these kinds of financially distress situations, the Board of Directors will often solicit investment from venture capitalists or angel investors. The idea is that the company will then use the proceeds from the investment to pay down the debts and free up more capital to invest in growing its business. A problem arises when the Board is unable to sell the equity for the price it needs to settle the debt obligations.
startup looking to increase their return on investment may choose to outsource the cap table analysis to a third party who can then provide an objective assessment based on their calculations. By choosing this third party, the investor has access to information that the Board cannot provide and this can help them make better decisions regarding their strategic equity funding needs. However, there is startup of interest when it comes to third party provision of such critical analysis. Investors may feel pressured into making a particular decision because they have invested in the company based upon the advice of a particular investment banker or financial analyst.
For this reason, post-money valuation caps are also being utilized by distressed businesses as a means to restructure their debt obligations. In startup , the owner is facing bankruptcy or financial hardships and they are unable to repay their debts. They may also be in danger of foreclosure if they proceed with selling the business. Selling startup based upon post-money valuation of its equity makes good financial and strategic sense, but it is also inherently risky for the distressed business owner because they are relying on the word of a professional and how they arrive at their conclusions.
A less obvious use of post-money cap table math is in the refinancing of an existing acquisition where the new owner wants to use convertible notes as part of the financing for their acquisition. In this case, the new owner would most likely refinance the existing acquisition using post-money valuation. This would give them a lower interest rate and terms than what they could get from a conventional loan. The new owner could then use these terms to lock in at least some of the price savings they get by refinancing the acquisition using convertible notes. Again, they need to ensure that they are able to lock in the price using their post-money options to protect themselves from default and foreclosure.
There are many other potential uses for post-money options and cap table math is only a tool that the savvy buyer can really make full use of. For example, many real estate investors have made a great deal of money using convertible notes as part of their investment strategy. The problem is that many investors have gotten so good at this that they have ended up overpaying for their option investments. As a result, they have paid too much for the protection afforded to them through convertible notes and have run into financial trouble. The key to finding success using this method is to have an effective pre-money option pool.
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