With participating preferred stock, in an acquisition or liquidation, the holder first receives their preference payout, then converts those shares to common stock and receives their share of the remaining funds.
Holders of non-participating stock need to make a choice. They can either receive the preference payout or convert to common and receive their share of the proceeds. In a positive outcome like an acquisition at a high valuation, all the preferred stockholders would convert. The preferences only come into play when the company is liquidated in a fire sale.
Avoid participating preferred stock if at all possible.
Fully Diluted Shares
One term that you're likely to run into as soon as you start working with investors is fully diluted shares. That's the number used to calculate the per-share price of your company.
The number of fully diluted shares equals the number of outstanding shares plus all the reserved shares.
The significance is that the board, without the consent of the shareholders, could issue options for every share in the options pool and warrants for all the shares in the warrant pool. Then all those people could exercise those instruments, converting them to stock. To value the shares, the investors assume all that could happen, so they use the pre-money valuation divided by the number of Fully Diluted shares to calculate the price per share.
In most cases, you don't include convertible notes and SAFEs because you don't know how many shares they will become until you close a round that will trigger their conversion. Until then, the effective share price for those investors is undetermined. These investments still need to be tracked alongside your cap table, but they are not actual shares yet.
Although the options pool is on your cap table, the options you grant are not. Nevertheless, you need to track them in detail and provide at least a summary to potential investors.
For every option grant, you need to record the:
Managing the cap-table
Keeping track of all this information can get complicated, particularly once you have several investors and employees.
You can certainly do it all on a spreadsheet, and there are many templates available for download. Going through the exercise of setting up your cap-table and running some scenarios for various outcomes can be educational.
However, I don't recommend managing your official cap-table yourself. There are many subscription services that can help ensure you don't make any mistakes.
Even innocent mistakes on the cap-table can be devastating, leading to epic legal fights and scaring off potential investors.
I don't have any specific suggestions for cap-table management tools because it is a fast-evolving space. Some quick searching will surface the current best options. There are many good choices at reasonable prices.
In addition to the cap-table itself, you need to track the SAFE or convertible notes, options, and warrants. You also need to have ready access to all associated board actions, shareholder votes, investor agreements, option agreements, etc. During due diligence, investors will probably require you to show documentation of every entry related to corporate ownership.
Even using a tool to manage this information, you should still have your experienced attorney review it. That outside set of eyes can turn up mistakes or omissions and demonstrates good faith in trying to have the most accurate picture of the company's capitalization.
The cap-table at incorporation