Six cap table management tips

Editor’s note: The perspectives expressed in this commentary are the author’s alone. The following is a paid thought leadership piece from Chris Schumm, McQueary Schumm Munsell Group at Morgan Stanley in Leawood, Kansas.

Cap table management can be more complex than it seems; Discover six ways to improve the accuracy of your cap table

A s the document that tracks the ownership structure of your company, your cap table (or capitalization table) should display the full list of individuals, institutions and other entities that have an ownership stake in your company. Yet, while it sounds simple in theory, maintaining accurate records regarding each shareholder’s security holdings has the potential to become quite complex. To help you avoid some common pitfalls, here are a few cap table management tips to consider.

Chris Schumm, Morgan Stanley

1. Understand option pricing

When founders first begin to issue equity in a company, they often choose to grant options. One of the challenges of these grants for private companies is setting a fair price for the options.

Under the US Internal Revenue Code (IRC), incentive stock options (ISOs) must be granted with a strike price equal to or greater than the fair market value of common stock. 1 Granting options too low could result in tax penalties for employees, excess costs incurred by the company and holdups during an acquisition or IPO. Conversely, if you grant options too high, employees may miss out on value they may have otherwise received.

To set a proper option value for cap table management purposes, private companies may want to consider obtaining annual 409A valuations from a reputable valuation provider. By determining the fair market value of your common stock, a 409A valuation helps set the strike price for your option grants and may prevent your cap table values from being called into question.

2. Understand the regulatory environment

To make sure the information on your cap table remains accurate and verifiable, you may need to comply with various different regulations. These may include:

• ISO $100,000 limits, which stipulate how many options can vest in a given calendar year to qualify for certain tax treatment. 2
• IRC 409A regulations, which require some companies to conduct a formal valuation at least once a year to determine an appropriate strike price for options. 2
• ASC 718, which is an accounting requirement for measuring and recording the expense associated with issuing equity-based compensation. 2
• Rule 701, which exempts some companies from registering with the Securities and Exchange Commission (SEC) before issuing equity-based compensation. 3
• 83(b) elections, which may allow certain employees to file an election within 30 days of receiving restricted stock awards (RSAs) to obtain preferential tax treatment on the sale of their equity. 2

To understand which regulations apply to you, consider consulting with a legal advisor.

3. Learn how to analyze the impact of a financing round

When a company raises a new round of financing, it will generally issue a new round of equity-based awards, such as preferred stock or convertible debt.

Preferred stock awards may have terms that govern an investor’s liquidation preferences, participation rights and participation caps. Similarly, convertible notes (such as KISS notes and SAFE notes) may include provisions outlining conversion caps, conversion discounts and warrant coverage. These provisions can sometimes mask how much dilution may result from the conversion.

To understand how a potential financing round will affect the cap table, it is important to model different scenarios and combinations of terms. Without this analysis, you may unknowingly give up more value in the company than intended.

4. Maintain good records

Cap tables come in all shapes and sizes but, at a minimum, they should display the types and amount of securities each shareholder owns, when they received their equity and what percentage of the total company they hold. This is important because, when it comes time for equity holders to sell, the cap table determines who gets what.

While this may seem straightforward, cap tables can be subject to rapid change. Unvested options may be added back to the cap table when employees leave the company or choose not to exercise them, new investors may replace existing investors and you may choose to issue more complicated equity instruments such as convertible debt. All these changes will generally be governed by a collection of legal documents, agreements and records that tell the story of how ownership in the company has evolved.

To accurately maintain this full record of ownership, it can be helpful to use a system that automatically updates your cap table when material events occur. Otherwise, new investors and their legal teams may discover errors and missing information. If there are significant differences between the legal documents of record and your manual cap table, for instance, your equity holders may find they are entitled to less than they thought. This can result in both legal and financial repercussions.

5. Consider consulting with a professional

While it is possible to find online templates and pre-built spreadsheets to help with cap table management, these cannot take the place of a qualified professional. A standard template for an option plan agreement or shareholder agreement can be a great starting point, but if you don’t understand each component of these contracts, it may make sense to work with someone who does.

As your company grows, you may encounter nuances and legal complexities. In many cases, you don’t know what you don’t know. As a result, you may realize after the fact that you could have gotten a better deal, or that you violated some regulation, or that you have to pay more taxes due to an improper filing.

With advance advice from lawyers, mentors, accountants and other professionals, it may be possible to avoid these missteps and enhance the accuracy of your cap table.

6. Automate cap table management

Although early-stage companies often choose to manage their cap table in a spreadsheet, this may lead to complications down the line. For one, cap tables generally need to encompass a wide range of supporting documents, such as shareholder agreements, vesting schedules, certificates of incorporation and a host of other information that can be tricky to maintain over time.

Additionally, spreadsheets are often error prone. If there is just a small typo in a formula, you may make legally binding decisions using faulty information. Similarly, it can become complex and unwieldy to use a single table to keep track of every transaction, including sales, transfers and cancellations.

To overcome these limitations, it may make sense to automate your cap table management by relying on an equity administration platform. Morgan Stanley at Work can help you manage all your equity in one place so that your online cap table can act as the official source of truth.

To learn more about how we can help streamline your cap table management, visit Morgan Stanley at Work Equity Solutions.

Footnotes:

1 KDP LLP. 409A Valuations and Stock Options . 2022

2 PwC. Income tax considerations—Employee’s taxable income . 2022

3 U.S. Securities and Exchange Commission. Employee benefit plans – Rule 701 . 2022

Disclosures:

Article by Morgan Stanley and provided courtesy of Morgan Stanley Financial Advisor.

Chris Schumm is a Financial Advisor in the Leawood, KS branch at Morgan Stanley Smith Barney LLC (“Morgan Stanley”). He can be reached by email at chris.schumm@morganstanley.com or by telephone at 913-402-5223 . His website is McQueary Schumm Munsell Group | Leawood, KS | Morgan Stanley Wealth Management

This material is not a solicitation of any offer to buy or sell any security or other financial instrument or to participate in any trading strategy.

Morgan Stanley Smith Barney LLC is not implying an affiliation, sponsorship, endorsement with/of the third party or that any monitoring is being done by Morgan Stanley Smith Barney LLC (“Morgan Stanley”) of any information contained within the website. Morgan Stanley is not responsible for the information contained on the third party website or the use of or inability to use such site. Nor do we guarantee their accuracy or completeness.

Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors or Private Wealth Advisors do not provide tax or legal advice. Clients should consult their tax advisor for matters involving taxation and tax planning and their attorney for legal matters.

Chris Schumm] may only transact business, follow-up with individualized responses, or render personalized investment advice for compensation, in states where he is registered or excluded or exempted from registration, McQueary Schumm Munsell Group | Leawood, KS | Morgan Stanley Wealth Management

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