All right. So in the first three lessons, we outlined some of the basic cap table terms and concepts that you need to understand as you start building out your company. Now it’s time for the fun part, where we start putting it all together in the next few lessons. We’re going to imagine a fictional company and follow the founding team through the whole process of legally creating their company, building their cap table, raising multiple rounds of financing, converting debt into equity and selling their company.

Along the way, you’re going to see in detail what each change in your cap table means and why it’s important to your companies. Survival and success. You ready? Let’s dive in.

Okay, So let’s run through the first four important steps in our fictional company’s journey. They are incorporation, how a co-founder split equity in the company, option pool planning and arguably the biggest thing I’m most founders’ minds. Dilution.

Okay. First step. Incorporation. Let’s say you and your co-founder have filed your certificate of incorporation for your new company called Meetly. The process is pretty simple and straightforward. You just say who you are, what your business is, and how many shares you’re creating. All right. Congrats. You now have a company that’s legally incorporated. And in that incorporation, Doc, you’ve declared that you’re creating or authorizing 10 million shares. This is a number we see pretty typically. But as always in real life. Make sure you talk to your legal advisors. But for our example here, of that 10 million, you and your co-founder are going to issue yourselves a total of 9 million common shares. That leaves 1 million common shares that are also authorized but just haven’t been issued to anyone yet. That’s a key difference to be aware of.

Just because the shares have been authorized. Doesn’t mean that they’ve been issued. You’ll see how this comes into play in a bit. Okay. So a couple quick things to know here.

First, let’s talk about founder equity splits. You and your co-founder can obviously decide to just split that 9 million shares right down the middle. That would be 4.5 million shares each. Or you can agree that one co-founder should get a little bit higher of the ownership percentage. Maybe the company was that person’s brainchild or maybe they’re going to devote more time to building the company or they just have special experience or talent that’s especially useful here. Whatever the case, this moment of incorporation is where you and your co-founder have to get together and make these important decisions. And just a little side note, you and your co-founder can go over to Carta and use our equity split calculator to help you figure it out. So for the sake of this example, let’s say you decide on a 5545 split, which as we talked about in our previous lesson, is a pretty typical ballpark for equity splits.

Now let’s talk about that last million shares that you’ve left on issued by leaving 1 million shares unissued. You’re essentially making sure that there will be shares available for other people like advisors, employees, consultants in the future. When you bring people on, this little pool of 1 million shares is where you’re going to distribute their equity from. All right. So let’s take a look at how all of this looks on your cap table right now. It’s pretty simple and straightforward in an automated cap table management system like cards. You’ll have several different options for how to view your cap table, for example, by sheer class showing that there are 10 million authorized shares of common, that 9 million of them have been issued and 1 million remain unissued.

Or you can click on another tab and see the capitalization by stakeholder. As you can see here, pretty basic. Nothing too scary. You’ve got two co-founders splitting authorized common shares, 55 to 45, and with a total of 10 million shares authorized. That means that there’s still 1 million shares available. One big thing to note is the price per share column right here. In some states, you’re required to list what’s called the par value or nominal value of the shares. But since your company really hasn’t had a chance to establish its value yet, you’ve listed some very small but nonzero like number, let’s say .0001 cents per share. Also check out this quantity column right here. You might be thinking, wait a minute, how does the founder own 55% of the company, but only 4,950,000 shares? Shouldn’t it be 5.5 million shares if the total number of shares is 10 million? You’re probably already way ahead of me here. But 4,950,000 is the right number of shares for 55% ownership because it amounts to 55% of 9 million, which is the number of shares that you’ve actually issued. Remember, those other 1 million shares have been authorized but not yet issued. So they’re still hanging out, waiting to be distributed to someone later. Okay. So right now, Founder A holds 55% of Mealey and founder B holds 45%. And this is super important because as you start adding more people to the cap table, you’re going to start issuing those unissued shares. And that is going to affect the ownership percentage of each person that’s already on the cap table. This process is called dilution. And right about now, in your very young company’s history, you’re about to experience it. So let’s talk about it. Here’s a scenario.

You and your co-founder get started. You’re working on a product. You’re coding. You’re plotting to take over the world. And you realize you need to hire a really sharp engineering chief that you’ve both worked with. This person isn’t exactly a co-founder, but they’re also not exactly an employee, right? They’re more like an important early advisor who has some skills that you badly need right now, and they’re willing to come help you out for a few months. But the problem is you don’t have the money to pay them. So you agree to give them some shares of the company. You and your co-founder get together and think about it and decide to grant 100,000 shares to this person in the form of options. It’s a good enough number that it creates an incentive for a very talented, very in-demand person to spend some serious time on your project. So you agree to issue 100,000 right now, essentially worthless, but someday maybe hopefully valuable shares to this advisor. Those shares come out of the 1 million share option pool that you reserved when you incorporated. So let’s now add this person to the cap table. We’re now looking at this. Notice how the number of available shares has gone down by 100,000. And also, notice how the co-founder’s ownership percentage is suddenly just a bit smaller. You and your co-founder still own the same number of shares that you did before, but now there’s more issued shares in total. The pie got bigger, but your slice didn’t grow with it. And this, my friends, is how dilution works. It’s a big thing to understand, and most people have a misconception that dilution means that they have to give away their shares to someone else, which is how their ownership percentage gets diminished.

But in reality, it’s the opposite. You’re actually keeping the same number of shares you had, but new shares are getting added into the mix, which means your shares are now a smaller percentage of that overall pie. Whenever you raise money, bring on new investors, advisors, employees, what have you. Dilution is going to come into play. The math can get pretty complex pretty fast, so it’s important to keep track of this stuff very carefully on your cap table from day one. Okay, So so far we’ve been talking about what happens at the very beginning when it’s just you, your co-founders, and maybe an early advisor. But what about when actual investors get involved? That’s when the fun really starts. So let’s say it’s four months into your company and you’ve made pretty good progress. Your advisors got you passed some common early minefields. They use their engineering know how to help you figure out some technical stuff, and you’ve managed to build an early version of your product. You’re innovating, moving forward, and it feels great. And now your idea and your product are starting to become compelling enough that some people with money want to actually give you the money. In other words, you’re ready to raise your first round of outside funding. And at this early stage, the first financing usually comes in in the form of a convertible instrument, which we talked about earlier. It’s either a convertible note or a safe, which, remember, is a simple agreement for future equity. So for this example, let’s say you decide to raise the first round of funding on a safe agreement. Remember, from earlier, a safe is an investment vehicle where the investor gives you money today and has the right to see that money then converted into shares at a later time.

When you actually figure out how much your shares are worth. Basically, it’s like the investor saying, I like you, I believe in you, and I’m willing to put in a little money on the table to see where this goes. So let’s say this early investor is a nice person named Carroll. Carroll offers you $100,000, which you decide would be really helpful to get you through the next few months as you continue to build the product and maybe even hire a couple of early employees. So you sign a safe agreement with Carroll, which includes a 20% discount and a $5 million valuation cap on the next financing round. We’ll explain how valuation caps work a little later. You’re now going to add her to meet Lee’s cap table. So let’s take a look at what the cap table now looks like. We don’t yet know how many shares the safe will convert into. Right. That’ll be determined by the next financing round.

And that, my friends, is where things start to get a lot more interesting. A.K.A., complicated. So when you’re ready, head on over to the next lesson and we’ll start digging into what happens next. When you start adding in investors to your cap table who aren’t using convertible contracts, but instead buying shares at a set price. So how does that affect Carroll’s stake in your company, and how much is it going to dilute the original founders? All this and more when we see you in the next lesson.