Understanding Equity Cap Tables w/ Marlon Nichols

Marlon is the person to give this talk. He's a C stage venture capitalists that invest in visionary founders, build in the future that the world wants to see. Some of his current in previous portfolio companies include Bravity which ons afro Tech, gimblet Media Listener, Maven, Mango, dB, Play Versus, and more. But I remember so much about this talk from afro Tech seven team is how full of knowledge it was things that were critical to the founders with

central outcome. Like in the music business, artists get so excited about getting a record deal that they don't read their contracts, therefore don't understand the economics of selling a record, touring or merchandise. In the world of startups. Too many founders get a big surprise when they go to sell and find out they're not gonna get as much of the pie, and say want to start because they're so diluted.

So founders listening, it's the holiday season and I'm preparing some more fire interviews for you guys that bring in the new year. But for now, enjoy this throwback. So we're gonna get into into cap tables. So basically, uh, where's our runner, I'm gonna I'm gonna start. I'll make this real interactive, right all right? Cool? Who can tell me what the cap table is? Anybody? Damn, it's on

the screen. Basically, it's your it's your it's your ledger, right, it's your it's your record for ownership within your company. And it covers two types of stock. Primarily there's common stock and preferred stock. UM. Again, everyone knows what the difference between those two are. Huh No, man, y'all do

your homework. I sent it out now. Um So, common stock is generally what UM founders get, and preferred stock is what investors purchase or um or trade, and the differences that preferred stock gets get some more UM, I guess privileges then common stock does. For instance, when you when you start thinking about change of control UM or wanting to raise more capital or anything like that, UM, the preferred stock owners are gonna have to approve that

in order for it to get done. So I guess the biggest the biggest thing you can take away from from me today is that once you raise capital from venture capitalists or any investors, you start to give up some control of your company. Right, all right, so cool. So what I did was put together this exercise, UM, where we're gonna pretend that, UM, we're an entrepreneur and uh, we're raising we're creating our company, and we're raising a couple of rounds of funding, and the first round of

funding is going to be a convertible note. Um, does anyone know what a convertible note is? We got one right there? Essentially, I think, if if I haven't right, it's a debt product that on your next round of capital converts into equity at a discount for your investors. That's perfect. And so the reason why UM, yeah, So the reason why UM, a startup would raise a convertible note as opposed to do on a price round or

a straight equity round. Initially, Um, there are there are a few reasons, but the primary reason is you don't want to you don't want to price it. So you don't want to put a price tag on your company before you started, because that that's gonna act as a trigger for further pricing down down the road. So if you're really if you're really early, and you don't want to say, oh, my company is only worth you know, two million dollars, you can do something that is a

convertible note. And um, you have this thing on it called a cap. I'll talk about it in a little bit, but um, that's uh implied valuation as opposed to a hard valuation. So you're leaving the door open to be able to either price your company up or down. Um later on makes sense. Question right here, can you do a convertible note if you have an LLC or is that also somewhere what arry ship earlier where you have to get a C corps if you're taking a lawyer

can answer that? Okay, Uh, the the answer The answer is yes, Um, you can't. Actually, it can't convert into equity until it's a corporation though. Yeah, And and if the I'm not giving legal advice here. I'm not a not a lawyer, but if you're gonna start a company and you intend to take on capital, then you should just start with a corporation, all right. So UM any other questions before UM? What are your opinion? What is

your opinion on a safe versus a convertible note? As an investor, I don't like safe, so UM if everybody else as safe as a it's kind of a derivative of a convertible note. UM. It was created by by the folks at y Combinator, and it's meant to be UM equally investor and and founder friendly. But really it's it's founder friendly. UM. So there there there there's some

issues that I have with it. UM One, there's usually not a maturity date on it, so this note can just live in perpect you as an investor, I'm I'm investing. I'm doing this note. I'm investing in your company because I want that to turn into equity. There's also a lot of times it's UM. It's very um coy about what happens. UM once this think converts, do I convert on par with whatever? Around UM whatever financing that's happening, and my junior to that and my senior to it.

There's just a lot of issues, um for an investor. So we've never done a straight um safe. We've always made those changes to it, so might as well just start with a convertible note. And I think, um, there's been some some reports from founders where they're also finding issues with the with the safe down the road. But it was meant to be, um, you know it was. It was a nice try, all right, yeah, M thank you.

Which side of the table usually sides, whether it's going to be a valued round or a convertible note, It depends really, Um. Most of the time it's the it's the founder. Um. But I'll give you one. I'll give you experience that I had where I had a founder that was coming out of Y combinator. Um h Lee Andrew had a hinge too, and he his intention was to raise a note, um, but he had he had done enough where it made sense to to to basically

price it. And UM. You know the thing that investors think about when it's when you're doing a note is there's some there's some there's some variables that you can't control there, right, You can't control what the valuation of the price round is going to be, so I prefer to know what that is and set that if I can. UM. But if again, like I said before, if a UM, if an entrepreneur is really early and you know they're the data is not there to properly said, then they

may prefer to go with go with a note. But it's it's a conversation. Sometimes it depends on who has the power. If it's a really hot start up and this is what they want to do and you want to end and that's what you're gonna do. All right, Okay, so uh let's move in everybody who did their homework. Dah. Okay, it's gonna be harder. Um, alright, So the first exercise, right, so we're starting this company. Um, we have m there

we go. We have ten million authorized shares in the company and two founders between the two of them are taking of that. So they're taking two point five million shares each, right, and um, this is their first round round of investment. And again it's a note. Um, it's a note. And uh they're taking in five k from from dope VC. That's me right, Um, there's a there's a cap on the note, which again is a is an implied valuation. And so a little bit more about that.

What what what this means is when UM when either when the note mature's right, so let's say we have a we have a UM A twenty four month term on this note, it then turns into equity at that point, this UM, this five million cap becomes the valuation right now, if there is a price round before that maturity date, then the valuation is at whatever UM price is set by that the investor that's leading that round, right. So if ah, here's here's the upside or the good thing

about UM notes. Potentially good thing about notes for investors is that if I have a five million cap and the valuation is set at ten million, then I pay as I pay a price of five million for those shares as opposed to ten million. So I'm kind of winning, right UM. But it's it's a pre visit I get for for taking the risk early. UM. And then you and then the other thing is the I'll get to you a second. The other thing is, um, you have a discount. So it's either or it's whichever is lower.

So if the you know, if it is a ten million dollar valuation. That's set um, and it's it's you know I have I can either choose between uh, taking seventy five price at seven s that or I can take the five million. Obviously five is lower than seven point five, so I'm gonna take five, right, Um. And then uh, there's it's a note, it's a it's a debt instrument. So there's interest that's accumulated every year. Um.

You had a question right here. I'm sorry give him my I was saying, initially, the value of your company is based on what in the smith you've got, or so how does that work? See your question is how how is the valuation set? Right? Um? It's kind of ambiguous. Actually, um it it can be. You know, an entrepreneur feels that their their company is worth this amount um from an investor's perspective, if they are tangible things like revenue, right, I'll look at that um and then apply a multiple

towards that that revenue. So let's say other companies in the space are let's call it trading at a four rex multiple. I would apply that four rex to to that revenue number, and that's how I get my my valuation. But then there are other things you got to consider too, like, you know, is this a return founder? UM? Has she sold a company before for a lot of money? Has she taken a company public before? Is it's the same team? You give them some credit for that sort of valuation?

Starts to inch up? Right? Is it a UM? Is it a really new and hot space? Is this deal really competitive? Is UM? You know Ryan over k poor capital trying to steal the deal from me and I gotta and I gotta outpriced him or something like that, Right, So, UM, A lot of things go into it, but generally try to find markers and and uh industry markets to help you figure it out. All right, So jumping into the model, I mean, if you can do division, you can create

a cap table. Right. That's that. That's all it is. So I'm just gonna try to walk you guys through this. Hopefully it's not too clumsy. Right. So we said that UM there were ten million authorized shares and the found each of the founders, the founder one and founder too. Can you see, Oh you guys gotta put that back up, Okay? UM? Sorry? So founder one, Founder two UM both have two point five million shares each, right, totally down here five million shares.

The valuation cap for the note was five million, So that's that's here. The the importance of the valuation cap is it determines what I'm going to pay per share um of stock. Right. So for instance, so basically, and what I'm gonna look at is the number of shares that have been allocated, right, and I'm gonna divide that. Um, I'm gonna divide the valuation by the number of shares that have been allocated, and that's how I get my price valuation per share, right, So it's just the vision.

So that's how I got to to one dollar here. Um, Now that's just the So that's the the comment I got in an investor actually two investors that put in five each dope VC and investor one right, totaling one million. Right. So so now there's been one million dollars invested into

the company in the form of a convertible note. And uh, the only other thing on on this on this exercise that um it's really important to point out is remember we talked about the purpose of having a cap table is to understand your ownership, Right, how much of my company do I now own? So as the founders with just that one million dollar investment combine, they own eighty three three of the company, right, which is a great place to um to be when you're when you're starting

a company. I think I have some trigger questions. Yeah, so we talked about the cap in the discount. So let's let's move forward to exercise two. Exercise two bills on exercise one. So you know, a year has passed and UM, my company has done well, and uh someone or your company has done well. I'm the investor. Your company has done well, and so you're raising another round of funding to help you with growth. Right, So what's gonna happen here? Your seed notes are going to convert.

They're gonna either convert at um the five million cap or or of the of the valuation. The the the investor, the new investor. They're gonna price this thing. So they're gonna set a pre money valuation of thirteen million. Anybody know the difference between the pre money and post money pre money, Yeah, she she got it. Pre money is um the price of the company or what the company is valued at prior to the investment, and then the

post money is um. It's an addition of the valuation of the pre and the dollars that came in UM after right, and so when you're when you're talking about before the round is done, you talk about valuation in terms of pre money, and then once the round is um has concluded, then you speak about it in terms of post money. It's uh so there there, there wasn't right,

because it's not an equity round. It's basically debt. At that point, the question was was the five million um cat considered a post or or pre and it's um, it's neither actually because it's a convertible note. It's a instrument at that point, and while you're holding a note, you're not actually holding equity and so there and so there isn't a true valuation at that at that point, Yeah, I already know the answer, but for some of them entrepreneurs here, so what is a the average interest rate

when giving out a convertible note? Who sets that? The investor or the founder of the company. Like everything involving a deal is everything is negotiable, right, So UM and independents, who has who has more power in the deal. But typically you'll have a lawyer and that law firm would have seen some number of deals similar to this, and they'll SAYY, the the average or the or the median interest rate is this, and so that's what they'll they'll say,

let's go with right. And as an investor, you know, I'm thinking about it from a you know, a risk reward standpoint, UM, and I may go up and I may go down, and it's basically just another negotiation, another level for lever for a negotiation. UM. Typically if you're really bullish on the deal, the interest rate doesn't doesn't matter so much to you, right, UM, there are other factors that are that are more important. So if the you know, if the entrepreneur wants to lower interest rate,

you're probably gonna do that, all right. And you know, if if things go as they should, the UM, the interest that you're gonna get over a year or a two year period is not going to really be material in terms of your your ownership. UM. So can you hear me? Can you hear me? So? What has been your experience with buy sell agreements and how do they what role do they play in this discussion about ownership evaluation? All right, we gotta read the questions in and keep

them about about UM, about this I can. I can catch up with you about that afterwards. UM. Okay, So it's a thirty million pre money UM. It's a two million dollar round. There are two new investors UM. One is going to invest a million, the other one's gonna invest half a million. I'm going to follow on and do UM do half a million in this round. And we're gonna we're gonna ask for a twenty option pool and we're gonna do it pre investment. So does anyone

know what an option pool is? Ahead? Yeah, So it's a it's a percentage of the of the UM common stock in the company that's that you're holding UM to either reward employees for for doing well or use it as a recruiting vehicle to hire. I don't know your CTO right because one of the one of the carrots or the main things about the main attractive things about UM joining a startup is a fact that it's you know, it's gonna grow and you'll have ownership within that startup.

So this option pool UM allows you to to basically award and UM reward your employees and soon to be employees with stock in the company UM. And so at the at the early stages. At the early stages, Um, you want a pretty hefty um option pool so that you don't have to to kind of create an option pool again and again and again, because as you create, as you increase that option pool, you you become deluded.

Right because remember it's price over um over shares, right, So once you start adding more shares, you lose, you lose ownership. I'm sorry back there, So you actually just mentioned the word delution. How do you think through from a term sheet perspective? Uh, you know sort of who gets deluded? When you know? Is it founders? Is it subsequent investors? How do you how do you think through that? Yeah?

So one of the things, one of the key things here is this pre pre investment, right, So I want that option pool to be created before I put my money into this round. And the reason I'm doing that is because once that option pool is created, at whatever time that option pool is created, whoever owns stock in that company, they're going to own less, right. So I want that to happen before I invest, and entrepreneurs might want that to happen after I invest. So again it's

another it's another point where we start to negotiate. She had a question here he's bringing mic being sorry the option pool being hefty? What do you mean by that with like a T or like what is oh it? It's it's gonna vary. I think UM anywhere from ten to For a really early company, it's fair. Um. Most of the times you'll probably get to fifteen or or

or ten percent at at this stage. Series A companies UM probably have an option pool around ten percent because at a Series A you probably have your most of your key executives in place, which are the ones that are gonna be awarded most of that option pool. UM. So you know, you can have a little bit a

little bit less. But in this case we're asking for for twenty and so in this spreadsheet, basically what we're what we're doing is we need to say, all, right, of that of those ten million authorized shares that we UM that we have, we need that to be in

the option pool. So for those of you spreadsheet jockeys out there, basically just run a goal seek um and uh you know so that you set this cell here to to equal um basically by changing the number here, right, So what happens is this number UM gets bigger and you can see that my price per share gets smaller. So that's the that's what that's what we mean by by delution. Now in this UM series A. Right, so

we're putting in half a million. These two UM investors are putting in one point five million total, which is a two million. The pre money valuation is thirteen million, and the price per share is basically calculated by the pre money valuation divided by the sum of the common stock plus the stock that was purchased in that note that's now converting into the equity. Everybody got that, all right? Now you can ask questions if you don't, but I'm

assuming you got it. Sure, I'll repeat it. So the the price per share is calculated by taking the value the pre money valuation, which we said at thirteen million, and we're gonna divide that by the sum of the total stock that has been issued in the company. Right, So um, the common stock plus the stock that was purchased as a part of the convertible note, because remember the convertible note is converting into equity at the first price round and that's where we are right now, I

got it already, A right? Cool? Um? All right? So now now we actually have preferred stock in the company. I'll get you in a second. Now we actually have preferred stock in the company, right, because we're investing in a price round series A. So now I have you know I had before, I only had fully fully deluded ownership. Right now I have preferred ownership and I have UM total ownership. Anyone knows why this is important? Bode care it comes It all comes back to control. It all

comes back to control. Right. So remember I said the difference between common stock and preferred stock is that preferred stock has more privileges, right and UM and they get to make certain decisions. Right. Can you sell your company for a dollar? If I'm an investor and I and I bought in for two dollars, I'm gonna say no, right,

and the other investors are gonna say that too. There's a concept of UM voting thresholds for for the preferred UM stock stockholders, right, so I could say maybe it's majority. So if we want a decision to go forward of the preferred or fifty point one or fifty point zero zero zero zero zero zero one percent of the preferred need to agree to move forward UM with whatever that measure is. So as you're thinking about your investors and

who you're taking money from. This becomes really important because there're gonna be some investors that you you really align with, that you think are are really good for your company, and they're gonna be other investors that you're like, right, it's they're okay, but um, but we need the money, so we let them in. And you just want to make sure that no one investor can make decisions about

your company all by themselves, right. So in this case, the VC almost thirty eight of the preferred ownership right, which means that I would then need you know, I would need Let's see, so I would need it. In most cases, I would lead to need at least two investors to agree with me or at least one other investor to agree with me in order to move that measure forward. And as a as an entrepreneur, that's something

that you that you want to make sure. Now you note that none of the founder the founders don't have any preferred stock right, And again that's because founders get common stock and investors get preferred stock. But what's still important here, it's how much of the company the founders founders owned. They got deluded now now they own combine fifty four of the company. So something else you've got to think about as you move closer and closer to

exiting this company. Right, and you've got to think about how much you're doing this for a reason? Right, You're doing this because at the end of the day, I mean, you may be doing this too for a social good, which is great. But at the end of the day, I think, I think we build companies to to generate wealth, and so your ownership is really important and unders standing you know, what you could get at the end of

the road is really really important. You have a question, can you can you talk a little bit about the impact of forfeitures or the explorations of option agreements to your cap table, you know how forfeit amounts are redistributed. That's a little beyond the scope of this exercise, UM, but I can talk to you about it offline afterwards. I feel like we'll get everybody lost. I missed how the note shares convert, like the actual five three five

converts into seven shares. But general answer to your question, UM, if let's say, let's say, UM, you awarded some number of shares to an employee and they have a vesting period. So that's another concept. So there's a vest investing period just means that you don't get all that stock at once, right, which is really really important because you want to incentivize your employees to stay and do and do a good job over a period of times, usually a four year period.

So let's say this employee leaves at the two year mark, so of UM, you know, of the stock that they've been awarded essentially would have bested, so they owned that there were the other fifty percent would go back into the pool, which is the gist of your question. But I know you want to get deeper, so we can talk about later. And I'm sorry. Oh right, So the the note and how it how it converted Basically, I'll

let you see the formula. So remember we had a seven percent We had seven percent interest on a note, right, so based and it's a year later, so um our initial investment amount which was UM half a million, just multiplying that by one point zero seven and that turns

into uh, you know this many shares. And and again the way that we're calculating those shares is we're taking the We're either going to take the price for share or the or the disc or the price for share based on the discount, right, Um, which one of these are we're gonna take as a investor the price of share, right, because it's we're paying less for it. Um. And the way that this is calculated is basically you're taking the common stock, which is all that existed in the in

the company. Um, you know when when we put our when we did the note, and UM, you're putting that into the the the cap right, which was UM five millions, got it? Okay, Yeah, I'm not sure if you're actually gonna cover it in the next section, but can you talk about the difference between cumulative preferred stock and non cumulative preferred stock and how UM that basically breaks down as far as like um, you know, invest their ownership in which one they prefer. Yeah, we'll we'll get to it.

Um towards the tourds inn um. All right, So uh three three in UM and four. I think we're running short on time. So UM, I think right, UM, the three and four will will trying to put together. UM. So exercise three basically we're gonna do the next round of funding. It's a year later, Series B twenty million, pre money. That's the that's the evaluation UM's ten million

dollar round. You've got two new investors each putting in five million two point um two point two million, and then um, all of the Series A investors are doing their parada um and for paradis means basically it's your ownership in the company before this round, and you're just basically multiplying that percentage. I can't hear you zoom in? Can you zoom in? Oh zoom in? Oh h sure, the help I can? UM? I forgot where it was?

Oh parata right, So basically you're multiplying your percentage ownership by whatever however much is coming into the company. Right, So if I own UM, well, i'll just show you in the in the model. So here we go. So Series B basically, UM, I can how's that all? Right? So UM, basically my Series B amount, I'm going to calculate it by taking my fully deluded ownership in the company, UM times the amount that's being raised in the round. Right.

So one of the terms in in the term sheet or in the UM the the investment documents is you might have a right to invest at your pro rata, right, So that that what that does is it makes sure that I can maintain the same level of ownership in the next round of funding, which as an investor is really important to me because I don't I don't like delution, right, and I'm thinking about the the carrot at the end of the trail, right, how much am I going to

get out of this thing when it's all set and done? All right, So all the other things are the same mechanics as before. Let's let's talk about UM exits, right. So at exit UM we're saying that the company is now doing two million UM in revenue, and this is two years after the Series B. The reason why the time matters is because UM we inventure capital and investing UM. The measure of UM of successes is I r R,

which is a time based metric. So it's not just the dollar amount, but it's how quickly did I return that dollar amount to to my investors. So the fact that it's not UM one year later UM is is really important. But so it's two years later UM after the Series B. There were no investments after the Series B,

which is also really important. UM. The reason why that's that's important is because if I did not participate I did invest in the Series B, then there's going to be some level of delution because there was no UM round and I didn't. There was no round for me to invest in. There's no delusion for me to worry about. Yeah, for those pro rata rights, do you have to put more money in as one of the original founders, um, when the money is raised in the Series B founders

don't have progrado rights, not founders, I'm sorry, the original investors. Yeah, So that that's that's what I was saying. If UM, if you if you have that privilege, if you have that right, then in order to maintain it, you have to invest whatever that number is in this round. If you don't, you lose it. Generally speaking, UM, five minutes okay, UM, So just to wrap this up, and we're applying to

exit multiple of five. So exit multiple is basically created in the same you get it basic basically looking at public companies and other private companies in the space, and you and you determine, UM, whatever that is. Maybe take the median of a bunch of public companies of their UM, their trailing trailing twelve month revenue, and you and you apply it. UM. So what we did here really quickly, uh two million UM revenue in revenue at the time, and it's an exit multiple of five. So the exit

valuation is basically a billion. And then um our our take of that is whatever our fully deluded ownership was at that time times that billion, which gives us basically a hundred and nine million. And then to calculate I R R you can create it to you guys have the table, but um, you basically create a table similar to this which basically here captures your your outflow. So what I invested as negative numbers and then ultimately what

I'm going to get back. And the formula here is basically just an X I R R on the on the eggs, the the the exit number, and and that's how you get to the to the end. Only other thing that um, you guys should I want to consider here is a concept of liquidation preference, UM. And so liquidation preference comes into account at the at the at the very end, right, the standard these days is one

x liquidation preference. So what that means is, UM, Remember I said that preferred has certain privileges that common doesn't. One of those privileges is that we get paid before you, the entrepreneur that's doing all the work, gets paid because we put up the money. It's fair UM. And so one x means that as soon as we um we get our ownership, whatever our ownership, whatever our percentage is of that return, then the common holders start to get

their returns right now. If you do something like a too x liquidation UM preference, now you're getting into a place where the investors UH is getting a little bit more than UM, maybe what some say, maybe more than what they deserve, but it depends on the situation when the deal was done. So now once we get to one x, right now everyone starts participating and including us.

So we're continuing to so right alongside you, I'm taking I'm taking more cash and more cash in until I get to two times my my UM my ownership in the company. So pretty A lot of people think this is unfair to entrepreneurs, a little um founder unfriendly. So typically it's one x UM, but really important for you for you to note in something critical for you to think about as you're thinking through and negotiating terms. And I think we are out of time, but i'd probably

take one question, one or two questions gentlemen. A gentleman behind me wanted to know if the slides were available somewhere, or do you have a course you teach. Yes, so in the number in in a few places so UM hbc uvc UM they they it's one of our interns. UM they have an online course and UH I provided some of the content for that, so you can find it there. Also the specific UM specific PowerPoint presentation and the Excel document I think had been sent to everyone

UM through through BT and afro tech. They didn't send along with the answers, but I'm sure they'll they'll do that right after the session, all right, thank you. Black Tag Green Money is a production of Blavity afro Tech on the Black Effect podcast Network and i Heeart Media. Is produced by Morgan Dabon and me Well Lucas, with additional production support by Love Beach and me Versus Lewis. Special thank you to Michael Davis, Sadam sims Ins a car Savon Jan you know like the wine. Yes that's

his real name. Learn more about my guests and other tech this innovatives to afro Tech dot count enjoying Black Tech Green Money leave just a five star rating on iTunes, Go get your money, Peace and love.