Operators need to know that something as basic as a cap table mistake can kill a cannabis company before it ever goes public.
When going public, your business will be under extreme scrutiny. And since you’ll be raising money from the public, the deal will need to be underwritten by a trusted bank. The bank will then be responsible for auditing all of your financials, including the cap table.
This article will review some of the most common mistakes operators make by using inaccurate information around their cap table. An incorrect cap table can cause the inability to receive a finalized audit opinion, preventing you from going public.
In addition, if your cap table is messy, who will want to invest in your business? A clear-cut cap table provides transparency for investors. They understand who they’re getting involved with and how they previously managed their business.
Who Manages Your Cap Table?
Typically operators manage their cap table with specialized software and a knowledgeable business professional, such as a CFO.
If you don’t have a CFO already, it may be time to hire one. Or you can save on their salary by outsourcing a trusted firm, such as GreenGrowth CPAs. Our trained professionals have a deep understanding of the cannabis space. We’ve worked with companies across the US at every stage in their business. For more information on how a CFO can impact your company, check out our YouTube educational videos.
Failing to seek professional advice may save you time and some money immediately. Although, the future cost could be incredibly high.
Why, you ask?
Because non-compliance with tax filings, inaccurate distributions of profits, and the inability to raise more capital can stop your business growth dead in the water.
Understanding the Story of the Cap Table
To understand how the cap table works, let’s first look at what the cap table tells the reader.
Cap tables are more than just percentages on a piece of paper, they are encoded stories of a company’s past.
The composition of equity allocations can explain a lot about what the company can do. It also encompasses the distribution of ownership and who is responsible for making the major company decisions.
We recommend understanding how specific changes can impact the business from the start of the cannabis business all the way through finalizing your exit.
Since your business story is constantly evolving, periodically updating the cap table is essential. Typical recommendations include evaluations when there is a new round of financing, additional share options are issued, or while reconciling vesting schedules.
One of the most significant mistakes founders make is using spreadsheets to manage their cap table. This causes everything to become disorganized and complicated because of the complex mechanics of how equity positions evolve over time.
As your company grows and gets funding, spreadsheets do not provide enough support to keep the cap table updated. This is especially important when used by multiple parties at the same time.
The EXTREME Importance of Data/Record-Keeping
Yes, managing a cap table may seem tedious, but it is a vital part of the financial operations of the business. In addition, you can make better decisions by understanding the intricacies of equity information.
For example, a thorough understanding is critical to know what portion of the company is available to give when raising capital from outside investors. You don’t want to give away too much or not have enough to give once negotiations start to move quickly. Also, investors will want to see who has control of the company by way of ownership.
In the case of an audit, a cap table that is periodically maintained helps your legal team accurately review the company history. They can easily identify changes in ownership and quickly provide detailed and accurate advice to clients who keep their information up to date.
Can compliance issues come from an outdated cap table?
The short answer is yes, and the issues can be extremely painful.
The biggest headache comes from compliance with the IRS and taxes. It hurts the company and can also adversely impact the employees who own shares as well. Getting compliance wrong can cost the founders, shareholders, and even the employees a lot of money.
The two most common compliance issues include:
- 83(b) election concerns the treatment of restricted stock awards, and it is critical to have it filed within 30 days of the grant.
- IRC 409A laws require an independent valuation of a private company’s common stock, which helps determine the cost to purchase a share. (aka the strike price for options)
In regards to cap table maintenance, compliance issues are easily avoidable if you take the steps to work with experienced financial professionals.
3 Common But HUGE Cap Table Mistakes
Mistake 1 – Immediate Vesting
One of the biggest mistakes operators make is giving immediate vesting for founders and critical first hires, including additional C-suite officers.
When starting a business, founders have an aligned vision, work ethic, and drive to succeed. But as we know, life happens, and issues arise. But this also means that founders can lose interest or change direction for personal or professional reasons.
The worst-case scenario is when a founder holds a substantial stake in the company, and they stop contributing. This could drag down the entire business, financially and emotionally.
Instead of immediate vesting, you want to look at vesting over extended periods. For instance, we recommend a minimum of three years. Or, better yet, developing performance-based vesting milestones such as revenue generated or units sold. By analyzing performance and measuring success, you can complete the vesting of equity by aligning incentives and consequences.
Whatever you decide, it’s critical to document and execute vesting parameters in great detail in your equity tracking document or software.
Mistake 2 – Not Using an Equity Tracking System
Another mistake we often need is the failure to utilize a system for recording equity and supporting documentation for those positions.
It’s imperative to maintain absolute assurance with record-keeping procedures. If not, it significantly limits the upside of the company. It can also reduce options for future exits and opportunities to gain liquidity.
Let’s look at two common scenarios.
What’s Wrong with Handshake Deals?
Though not a recommended practice, many operators in the cannabis industry still operate on “handshake deals.”
Lack of documentation and formalization of verbal or handshake agreements can lead to significant problems down the road. Your operation runs a massive risk by not clearly outlining business deals and how they impact the business’s financials, such as how you are distributing ownership. And this can lead to misunderstandings when the stakes are significantly higher later.
We always recommend that our clients get something down on paper, signed, and agreed upon by all parties. And for more cumbersome business deals, engaging with separate legal counsel may be necessary.
If all goes well, look at the contracts twice: once when you sign and once when you cash out!
Utilization of Poor Record-Keeping Systems
A second common scenario is that some cannabis companies may use a spreadsheet to track stakeholders, such as people and other organizations that own equity in their business.
We’ve also encountered operators relying on paper contracts or emails to document a paper trail for equity. At the same time, some operators still don’t have any monitoring in place or set schedules to review equity holdings.
Either way, this type of laissez-faire attitude towards ownership is incredibly hazardous to a company’s financial well-being. Why? Because you’re dishing out access to your business blindly.
What if you get locked out of old emails, and the contracts are no longer available? Or what if old data needs to be backed up or appropriately monitored?
The most important takeaway is to operate with the guidance of all your important documents to substantiate the ownership allocations of your business. Legal battles over equity can be costly, personally tiring, and leave a blemish on your brand financially.
You desperately need a sound tracking system to monitor your cap table distribution effectively. This responsibility generally falls to the CFO of your company.
However, if you need a CFO or are unsure how to get started, we have an Outsourced CFO service at GreenGrowth CPAs that can do the job for you. If not done correctly, this can create huge problems when trying to go public or even raise your next private round of capital.
Mistake 3 – Exercising Options Too Late
The last mistake we will review covers how operators and their employees utilize their options too late in the game.
Incentive stock options can have substantial tax advantages.
For example, say a company is still private and a few years from going public. At this point, when employees hold these options, they are not responsible for paying taxes on the purchase of stocks. And they only pay after the sale of the stocks. Buying and selling the stock happens on different days, which can be years apart.
In this first example, the shareholders only pay long-term capital gains taxes (if stocks are held over one year). This means lower tax rates than ordinary income taxes or short-term tax gains.
Now, in a second scenario, if the options are exercised as the company goes public, the buying and selling of the stock happen on the same day. This means the tax would be higher since the holder gets the income instantly after exercising options.
Employees (and other stakeholders) pay ordinary income taxes on their received value by exercising options too late. And the tax rate can be up to 37% for these scenarios.
Need help maintaining or reviewing your cap table?
To learn more about reviewing your cap table before going public or raising additional funding, please reach out to our team of financial experts at GreenGrowth CPAs. We are here to help your cannabis venture through any level of the accounting, tax filing, or business cycle.
We employ several financial programs to assist the company with its fiscal responsibilities, including tax planning and compliance, outsourced CFO support, audit preparation, tax controversy support, and much more.
For recommendations and assistance with tax planning and accounting services, schedule a free consultation or contact us at 1-800-674-9050.