The details of the Shareholders Equity section of your Balance Sheet are shown in your Capitalization Table, which is maintained as a separate report. The “Cap Table” shows how much of the company each shareholder owns, and in what form — common stock, preferred stock, options, or warrants. Investors will want to look at your cap table to understand how you have distributed your common stock and how you have raised investment capital.
Most important to investors, they’re going to look at your cap table, your capitalization table. How you have raised money and who owns the company. So it’s a part of your shareholders’ equity section of your balance sheet. The cap table shows the different classes of ownership in your company.
Inside your cap table you’re going to have the people who own common stock. Generally that’s the founders. It may also include some employees, and maybe even some advisors who might have common stock. It will also show stock options. And those are options that are going to be granted or have been granted generally to employees that will in the future become owners of your company. But they’re not generally issued yet, so there’s a reserve for stock options.
The other thing that may show up in your cap table are warrants. This is sometimes confusing to entrepreneurs because it’s unclear, what’s the difference between an option and a warrant. Well, an option generally is governed by regulations regarding qualified stock options, which the IRS regulates in terms of their taxability. Warrants are the more standard form of financial instrument, which are really an option to buy stock in your company at some point in the future as a fixed price. That’s what a warrant is. Frequently companies, startup companies, will issue warrants in conjunction with doing things like a lease or doing things like debt. So you may find out that you have warrants on your cap table.
The next thing is preferred stock. So when you have an investor like a venture capital firm invest in your company, most likely that investor is going to insist that they get preferred stock in your company. Now what’s the difference between preferred stock and common stock? Just as it sounds, preferred stock has preference over the common stock. The preference generally relates to having an advantage when the company is liquidated or sold, the preferred stock gets their money back first before the common stock. The preferred stock may also have some other preferences written into the contract when you sell the preferred stock.
The last topic I want to touch on in your capitalization table is convertible notes. Now we generally recommend for very early‑stage startup companies, when you raise money from friends and family, even if you’re raising money from angel investors, rather than creating preferred stock, what you can do is create a convertible note; a debt instrument that is convertible into equity. So it’s a great tool for raising money from friends and family and from smaller investors.
The idea of a convertible note is we aren’t sure exactly how to price the value of your company now, but we know we want to be part of it and when a bigger investor comes into your company, we want our investment in your company to convert on the same terms or even better terms than that new investor. So those are called convertible notes. Those need to show up in your capitalization table as well so that any investor who comes along to look at your company can see all the different people who have been involved in founding, co‑founding, working for, advising and investing in your company. Just make sure that you’ve got a complete, detailed capitalization table that is up‑to‑date all the time.