84. The Cap Table, Part 1 (John Buttrick & Sean Moran)

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John Buttrick of Union Square Ventures & Sean Moran of eshares joins Nick to cover The Cap Table, Part 1. We will address questions including:

  • John, can you walk us through your background and how you became involved in venture capital
  • Can you talk about your experience at USV and what you are focused on there?
  • Sean, can you walk us through your story, your path to eshares and your role there?
  • We’ve discussed cap tables on the program in the past but have never done a deep dive. Just to get everyone on the same page, Sean can you start us off w/ overview of what a cap table is and what one can expect to see on most cap tables?
  • Sean Moran cap tableJohn, I’m sure you’ve seen many cap tables as an investor. Can you mention some of the common issues you come across when reviewing a cap table?
  • Many of the cap tables that I review at the seed stage are pretty simple tables in an excel or google sheet. Sean, why the need for an automated solution?
  • What is a 409A valuation?
  • John, what’s the biggest value for investors of a clean and potentially automated cap table?
  • Sean, what’s the biggest value for startups of a clean and automated cap table?

Guest Links:

*Please excuse any errors in the below transcript

Nick: Today we welcome # John Buttrick and # Sean Moran. # John is a partner at # Union Square Ventures in New York city. And he manages Union Square Ventures Opportunity Fund and also focusses on earlier stage investments in the financial sector. And # Sean Moran joins us from Mountain View California. # Sean is Head of Investor Services at # eShares. And previous to #eShares, # Sean worked in Products at # Circle Internet Financial and also worked in venture at # Lightspeed Venture Partners. # John and # Sean, welcome to the program.

Sean: Thanks for having us # Nick.

John: I look forward to it

Nick: Absolutely. So # John, can you start us off by walking through your background, and also how you became involved in venture capital?

John: Sure. So my primary graduate schooling was law school. I went to law school and then after I graduated I joined a large law firm in New York. Spent a few years in Paris but I was focused primarily in New York, which is where I grew up. And did mergers and acquisitions. I also did some formation work. A number of my clients were large private equity firms. And during my legal career, which was about 15 years, I had absolutely zero contact with venture. I couldn’t have told you what a Series A round was if my life depended on it. And so in the late 90s, in the go-go days of the late 90s, one of my clients, a small small private equity firm that had a couple of partners asked me to join them. They were focused on buying back office software companies. They were backed by # Thomas Lee and # Blackstone. And while I was actually pretty happy, I thought this was sort of a, a really interesting opportunity for me. I’ve always been interested in business. And so I joined as the third partner there. But these, these businesses, that # LiveWire did, it was called # LiveWire, were sort of back office software companies. We did have an incubator that I guess today we, we would say invested seed and maybe the equivalent of Series A in some startups around the mobile space generally speaking. My two partners ran one of the small cellular telephone companies, New York Stock Exchange traded cellular company, it’s called # Price Cellular. And so we made investments around that ecosystem. And so I joined in early 2000 and spent about 4 years there. We sold our core companies pretty successfully and after that I started to be involved in a bunch of completely unrelated projects. And I got an introduction to a classified company. It’s essentially competing with # Craigslist in Europe although the headquarters were in # Union Square. So I started consult for them. And that was really my first exposure to venture. And I also, I knew # Brad, my partner # Brad, and I started to get exposed to venture because he and #Fred were raising in 2003 their first fund together. And I’m a small investor in the first fund. So that’s my connection with # USV. I then, one of my other projects worked with my now partner, #Albert, who is doing a separate venture, something called # Eckford Capital investing in transportation software. And I advised them on forming their entity and also looking at investments. So # Albert and I had a professional relationship. And he then joined # del.icio.us which was a #USV, one of USV’s first companies. And then he joined # USV and then I talked to # Brad and # Fred and # Albert probably starting in 2009 about starting a later stage fund. You know, they had made some very successful investments in 3006 in companies like # Twitter and # Zynga and # Etsy. But we run relatively small fund sizes here. The 2004 fund was $125M , and they were unable to follow on to their best investments. And so in 2010, I joined the firm half-time. When we formed the, the USV, the first USV opportunity fund, which is essentially a later stage fund. It’s a little bit more than that because it’s, we do think of it as an opportunity fund. And we generally think of it as involving investments in companies who have valuations north of a $100M that have less downside risk than our sort of core early stage funds.

Nick: Right

John: So yeah, so that’s how I came into the venture space and then in 2012 I joined as a Partner when we raised our 2012 fund. # Albert joined when they raised 2008 fund, and then I, I switched to full-time and joined as a partner at the 2012 fund along with # Andy Weissman to make early stage investments. So that’s how I came to where I am today.

Nick: That’s quite a career you got there. Lots of the, the thought leaders that I’ve been following for many years. Okay and then Sean, on your side, can you walk us through your story? Your path to #eShares and then also your role there?

Sean: Absolutely. So I started my career at # Ernst and Young, focusing on financial statement audits and then also working on some transaction analysis. Then I joined # Lightspeed Venture Partners as you mentioned. I , so I started there focused on financial analysis. So existing investments, looking at portfolio companies, how they’re performing, where we should double down. And then later I had an opportunity to work on a fund raising there and then moved to the deal team as an associate. So I spent 3 years at # Lightspeed. We invested into companies like # Snapchat and #Nest and # Nutanix Onus company. So it was a really great experience. I left to go to business school at Wharton. And then most recently, as you mentioned, was on product team at # Circle, which is a consumer bitcoin company. At # eShares I lead the Investor Services team, which is focussed on portfolio management. And we think it’s the best place to track and manage your private assets. I started almost a year ago and now I think our team is about 10 or 11. We’re pretty excited about what we’re building.

Nick: Very cool. And Sean, you know, we’ve discussed cap tables many times on the program in the past, but we’ve never really done a deep dive. So just to get everybody on the same page, can you start off with just an overview of what a cap table is and what one can expect to see on most cap tables?

Sean: Yes. So a cap table actually is short of capitalization table. And that’s the record of ownership in a company. So on the left you have the, the list of stakeholders typically, individuals or entities that hold securities in the company. Across the top, you’d see classes of stock. So you’d see common stock, you know, Series A preferred stock, Series B options. You’d be able in the cap table itself to see both the outstanding ownership in the company and also on a fully diluted basis, which would take into account preferred stock on an as converted to common basis. You’d see options issued, remaining in the pool, other convertible securities like warrants. And, and some cap tables you may not see this. But in every cap table I think you should see price per share of each round. So then you’d be able to see either in separate columns or you could do the math easily, the dollars invested into the company. So truly how the company is capitalized. It’s a, it’s financing history.

Nick: Which price per share was on every cap table?

Sean: Yeah, it really should be I think. Otherwise I don’t think it’s a true cap table, but it functions maybe closer to a ledger of securities issued which

Nick: Right

Sean: I think is a relic of, that law firms have, have typically owned this process in the past for private companies. But I think a true cap table should have price per share of each round and the dollars invested into the company. Not just equity but that, you know, is true how the company is capitalized. But typically for private companies, usually if you see a cap table it’s focused primarily on equity.

Nick: Very good. And then, # John, I’m sure you’ve seen many cap tables as an investor. Can you mention some of the common issues you come across when reviewing a cap table?

John: Yeah, well I think the most interesting thing to think about initially, which is why # eShares is different, I mean, I think everybody who listens to this podcast who has looked at a cap table has looked at an Excel spreadsheet. That is typically the way we historically have looked at cap tables. And those are sent by email. If you think about it, going back to, you know, I was a history major and there was always a distinction between primary sources and secondary sources. And primary sources were the actual source and secondary sources were sort of what we called in the legal world more heresy. And an Excel spreadsheet is by definition heresy. There are certificates that underlie it, but somebody, you know, tries to transcribe the information from the certificates and the documents to the cap table. And things can get lost. So the, the major issue with cap tables is accuracy. And many cap tables are inaccurate. That’s just the way life is or has been. And they were also complicated because different, you know, in the venture world we focus primarily on preferred stock, and different preferred stocks have different terms, you know, do they convert one to one, is there a ratio, has there been a split, etc, etc.  The cool thing about # eShares is it is a primary resource. It is a transfer agent. So when you call a cap table of a company off  # eShares, you are getting a primary resource that you don’t get anywhere else. And so I think it solves a huge problem. It also, you know, because it’s cloud based, that you getting something that’s a 100% accurate at that time. Or # eShares also has the capability to give you, you know, in the case of today where we’re here in May of 2016, let’s say you wanted to see the cap table at the end of December 2015 for year end financial statements, just press a button and out comes the primary resource for that date. So it solves, for those of us in the investment world who are looking for real accuracy, # eShares provides that.

Nick: Gosh, I really hope my portfolio companies are listening. Because I wish they were on this. You know, speaking of certs, I’ve never even seen a physical cert. Does # eShares hold the stock certificates?

Sean: So the answer to that is yes. And actually it’s a bit more nuanced. So first, for the electronic certs, there is no paper version that’s valid anymore. When a company signs up for eShares, every shareholder signs a legal disclaimer when they sign up. It effectively says that the paper certificates have either been destroyed or they acknowledge they no longer hold any value. And so the electronic certificate or security in the event that it’s not a stock certificate but a convertible note or a warrant, that is the, the only source of truth at that point. Just as a small side note, we do also hold in custody for our investor, our paying investor customers, paper stock certificates, as they are trying to convince their companies to sign up, we, it functions as a bridge where we’ll hold the on paper until the company is ready to sign up and then we’ll move from there.

John: But just to give you an example as a user, you know, I’m obviously invested in # eShares if I pull out and I go on an eShares account, look at eShares cap table, I see a number of shares but there’s also a button to actually click on a PDF of the certificate. You know, one of the headaches of the back office world is that they often can’t find the certificates, you know

Nick: Yep

John: You’ve never seen one. And so you have to do affidavits, you know, more paper work, more headaches, and # eShares solves that problem.

Nick: So one of the cap tables I’m looking at, you know, first money in, second money in, they’re pretty basic like you said, there in an Excel document or a Google sheet. # Sean, why the need for an automated solution?

Sean: So I think first, you know, for anyone that thinks it’s crazy that in 2016 you’re managing any part of your life on paper, we’re there for you. You know, I think if you’re doing it on paper and then separately logging it into Excel, Google sheets, you know, # John’s point stands, you have this double entry problem. Which is just, there’s this tremendous potential for errors. So what we fundamentally do at an atomic level is we bind together issuance and management into one step. So we fundamentally are a transfer agent where we are responsible for issuing live securities. When you issue and manage in one step, that means all the securities you issue become the single source of truth for the company. So all these problems before with managing spreadsheets that you get to a version control go away. Because there’s just one database that contains all of the items in the company’s ledger over time, issuance, you know, transfers, any repurchases or terminations. And I think what you get and what our companies have seen, our customers have seen, is that when you do this electronically and the law firms not managing the process on paper anymore, first you, you remove the chance for error. But second you really should save some money. So, you know, law firms are expensive 500 bucks an hour to not just do all this work on paper, which takes more time, but then also reconcile when you do encounter, you know, errors or issues. You know, there’s one reconciliation process in # eShares, which is just to get your current cap table live on the site. And then no more. I think the last point I’d make is just that when you have moved to a digital answer here, it’s just like many other things where you move from analog to digital, where there’s just a lot more power as a result, and flexibility to model your next financing round, run a waterfall analysis, produce a 409A valuation. All of those things rely heavily on the company’s cap table. And if you’re managing it in a separate spreadsheet all the time, then that means you’re constantly having to rejigger that spreadsheet for every new scenario you might want to look at versus if it’s just maintained in a clean database and then you can make use of building on top of that, which is what we’ve started to do.

Nick: Yeah, you know, speaking of 409A valuations, can you touch on what those are?

Sean: Sure. So 409A is actually a section of the tax code. So the IRS essentially looked at all of the, as John had mentioned earlier that the go-go days where, you know, companies were issuing options and, you know, they certainly were priced significantly lower in the 90s than maybe what the options should have been worth. And so the 409A valuations were brought in essentially to say you should be doing on, you know, a yearly basis really because these are, should only be valid, you only have coverage for up to 12 months, there’s the Safe Harbor mark that you meet there. But you should be refreshing the company’s valuation every 12 months at a minimum or maybe more often than that if there’s been a material financial event. And so this quickly turned into a racket where there would be these valuation shots that would just essentially only offer this service. And it would cost companies a lot of money to run the valuation. And so we saw this, this wasn’t, I don’t imagine the pitch to, to #John and #USV when the company, when #eShares started is we’re going to turn into the world’s valuation practice for 409A. I don’t think that would be a big enough market for #Union Square. But I think this fit into the kinds of things that you could do more easily if you had a database that maintained company ownership. Because if you feed the company’s cap table data and financial data from Quickbooks or Xero accounting directly into the valuation model, you could save a lot of time, you could do it for a lot less money. And, and that’s what we’ve started to do. So I think we run the largest 409A practice now for private companies. And it starts at $25 a month for coverage. So one of the things startups are concerned about is am I actually covered, you know, can I issue options to my employees at a price that, you know, is defensible in audit? And so that’s, that’s where our valuation team can help.

Nick: So John, in your estimation, what’s the biggest value for investors of a clean and potentially automated cap table?

John: Well, I think I talked about one of them which is , which I think is the most important, which is that you’re getting capitalization information from a primary source. So it’s a 100% reliable. Which is a critical, critical element. And number two, is you get consistency. Like I get a lot of cap tables, they’re formatted in very different ways and # eShares has a very standard format that obviously will iterate on over time but it’s, it’s great for me because I know exactly what they’re expecting. I think anyone who spends a lot of time on cap tables appreciates sort of a consistent approach because it’s all over the lot right now. And the third thing is, you know, Sean has been talking about what I call the VC product, which is, you know, we’ll show all of our investments in a particular fund on one screen or all of our funds on one screen. There’s a lot of data analytics that you could do off that. And, you know, there’s just no other way to do that unless it’s, you got a powerful cloud based system, you can, I mean you’re a seed investor, I don’t know how many investments you have but you know how complicated is it for you to pull up aggregate data and analyze it?

Nick: It’s not possible

John: Yeah, it’s a pain, it is not possible. You could hire an intern all summer to do some really basic things. And, you know, I think # eShares is working on a product that’s, it’s still sort of in the internal phase but it’s a big focus for us in a team in 2016 that is going to make all of this a lot simpler. And the people we’ve talked to who run seed funds and VC funds look at this and go, you know, can I get this yesterday? So I think there is a lot of interesting things that an automated cap table, a cloud based automated cap table, can provide. I think we’re just scratching the surface.

Nick: Yeah. Between my partner and I, we’ve got a little over 80 investments and I couldn’t imagine every quarter, pinging all these founders for the updated equity breakdown. I mean it’s just not possible. I mean, there’s, there’s no way that I could get access to this information. So if I had a group of LPs invested in a fund, I don’t even know how I could generate the reports without some sort of automation on, on the cap table.

Sean: Yeah Nick, let’s talk. I didn’t realize you were that prolific, you know, 80 investments, you really need a solution. So, we have this, we have the same same last name, no relation but I’ll still give you a family discount.

And you know there are other parts of it, I mean Nick I don’t know if you have audited financial statements but, you know, our analysts and every analyst and every VC firm and private equity firms,it’s not, we’re starting in VCs but I expect to go much broader than that over time. You know, there’s this huge year end process which just as you say you got to find get the most recent cap table at the end of the year, you’ve got to collect all the documentation relating to each investment, it’s very very cumbersome. What if you had all your companies on eShares? And for each investment there was the documentation for that investment? And the cap table was up to date and you just gave your auditor read access to that information, you wouldn’t have to set up any more drop boxes or whatever process you use in particular if you have audited financial statements. I mean, it’s just a game changer, I think. In terms of back office processes for, for funds. And it’s not limited to VC funds. It’s, you know, there’s private equity funds, there’s real estate, there’s oil and gas, I mean, there are tremendous opportunities here, you know, in capital formation aggregation I guess is part of the words I would use for that.

Nick: So in my own self interest of course, I want to hear the investor perspective on this. But Sean, can you give us a little bit of the startups perspective and why that clean automated solution on the cap table is, is going to be much more helpful for them?

Sean: Sure, yeah, I think John said it just right. But let me, let me echo what he said but also add, I think one of the first calculations a company might do, a mental math, is just, and obviously our sales team can help, is lower legal bills to start. You know, they, it’s, you’re not managing this process on paper and dealing with a reconciliation anymore. And so that should save you know the $500 an hour, that adds up quickly. So that will be the first thing, it will pay for itself just in, in that alone. And then, you know, as #John mentioned, there’s a variety of powerful things you get as a result. Just all the different views into the cap table and making that available to your investors can save you a lot of time, you know. As an example, if you have an investor on your cap table, they’re pinging you every quarter or whenever they want for access to this information and most updated cap table. If you’re on #eShares they ping you once for you to grant them access and then they always have access. You grant the permission level that makes sense. But then they can come in and download it and do all the modeling they want whenever they’d like. You don’t have to get pinged again on it.

Nick: Is it possible for the founder to model out their return based on potential subsequent financing rounds, exit prices, things of that nature to see, you know, how dilution may affect them down the road or how maybe a late stage ratchet could affect their position?

Sean: Absolutely. Yes. So when we issue securities, when a company actually issues securities, we capture all of the economic data associated with each share class or each instrument, and so each security itself. So we have these two models that may be relevant to do the kind of analysis you’re talking about Nick. So one is the next round model when you’re anticipating your next financing round, you click a button and you have a full model built on top of your cap table, you know, in an instant. And you could immediately start tweaking assumptions on what the, you know, valuation would be on the next round, and what kind of participation might you see from existing investors or from new investors coming into the round. Maybe you’re, you’re doing refresh of the option pool. Or note holders, you know, are converting into the round. All of that gets calculated for you. So you just plug in a couple assumptions and then you can see the resulting dilution affect on your ownership as a founder or as an investor you can use the same tool. The other analysis that may be relevant is the waterfall analysis. So the, you know, what would an exit scenario look like for the company?

Nick: Yep

Sean: Because we capture the preference data, the liquidation preference data on each share class. The waterfall analysis connects the preference stack to the cap table. And so you can see the funds flow projected for each share class, you know, whether it’s a common exit or clear preferences. And then also to each individual shareholder if you have that level of access.

Nick: Unreal. I got to get a demo of this. Because I was just going to ask you that question. I’m glad you covered it. So you also touched on this option pool, and John, I’ve heard from many founders that are getting caught up in the option pool shuffle so to speak. Can you describe what that is?