Old MacDonald had a cap table
October 28, 2015 § 26 Comments
For some readers a little background may be helpful before I talk about commercial banks and deposit accounts. Others may prefer this over the use of pharmaceutical sleeping aids or alcohol. I’ll try to keep it short.
Ownership, broadly understood, is simply to have a legitimate claim staked in some actual property. There are many different forms of ownership.
Suppose we have a farm which is owned by a group of investors. In anticipation of future discussions I’ll sometimes out of habit refer to the collected assets of the farm as the balance sheet of the farm; in fact the balance sheet more strictly speaking includes not just the assets (inventory of what is owned) but also an inventory of what is owed (liabilities + equity), that is, what the farm “owes” to various parties (workers, investors, customers, suppliers, etc). These always ‘balance out’ to zero; thus the name ‘balance sheet'.
The farm is not a person, of course, so to say that it ‘owes’ something to Bob is simply to say that Bob is entitled to that something to the extent that it can be recovered from the operations and assets of the farm. I’ll sometimes habitually refer to things that the farm ‘owes’ to various parties as ‘claims against the balance sheet’ or the like.
These various claims come in two flavors. The operating flavor is what the investor/creditor is entitled to while the farm is up and running, producing crops and making profits (or incurring losses). The liquidation flavor is what the investor/creditor is entitled to when the farm is being liquidated, that is, when the farm itself or its assets are being sold off.
A capitalization table (cap table) is just an inventory of the investors and their claims. The claims each has depends upon the kind(s) of security (investment contract with the farm) he owns. Securities come in all sorts of flavors and a virtually infinite variety of contract terms, but for the sake of simplicity we can speak of two basic kinds: equity (stock) and debt (bonds).
Debt is entitled to repayment of principal and a fixed rate of interest on a predetermined schedule, and has liquidation preference over equity. That is to say, if the farm is in liquidation the principal and accrued interest on the debt are fully paid from the assets before the equity holders get anything at all. Debt is obviously lower risk than equity.
Equity gets whatever is left over after all other claims have been satisfied. Equity has more profit potential than debt, but is much riskier. While the business is operating equity gets all of the profit in excess of expenses (including, in the expenses which have to be paid first, payments on outstanding debt). When the business is liquidated equity gets everything that is left over after all of the ‘fixed’ claims have been paid. So the profit potential for equity has no theoretical maximum; but misfortune can easily reduce its value to nothing.
Notice that nowhere in this basic capital structure has any person made a personal guarantee of repayment.
 The reason a balance sheet balances out to zero – that the sum of what is owned is equal to the sum of what is owed – is because once all of the creditors of various sorts have been paid what they are owed, any left over assets belong to the holders of equity. Equity is often itself referred to as ‘ownership’, although this is obviously a more narrow category which simply means ‘entitled to whatever is left over after everyone else has been paid’. There are kinds of equity which do not involve any formal ‘say’ in how the company is run, and the market does take that difference into consideration: a contemporary example is the difference between GOOG and GOOGL.
 I’m ignoring matters of operating control for present purposes. Usually debt investors are passive, whereas equity investors are active – that is, equity investors elect the board of directors.
 Assuming that no claims extend beyond the assets of the farm-as-actual-property to personal guarantees: that is, assuming no usurious contracts.
 The reason a balance sheet balances out to zero – that the sum of all assets is equal to the sum of all liabilities –
Just a pedantic point of clarification for the many out there interested in double-sided entries: the sum of assets is equal to the sum of all liabilities plus stockholders’/owners’ equity. The only time the sum of assets will equal the sum of liabilities is…when the sum of liabilities equal the sum of assets, in which case owners’ equity is zero.
Right, I am lumping what is owed to equity holders (the remainder after liabilities are satisfied) together with what is owed to everyone else.
Never thought of it that way, but doing so would have helped me in 101.
It is a good quibble though, I should probably tweak the words. Maybe instead of assets I should say “everything owned”, and instead of liability I should say “everything owed” to be more terminologically correct. Thoughts?
A lot of the deals I’ve been involved in used convertible notes, so I tend to mentally lump equity and debt together on one side as ‘investor liabilities’ or ‘finance liabilities’ with other stuff (payables and such) as distinct ‘operating liabilities’.
[…] Source: Zippy Catholic […]
I got impatient and tweaked the OP; but by all means chime in if you’ve got more feedback.
Your use of assets = liabilities made sense, but your change in wording will keep the pedants such as myself from asking what about the equity?
Not that I grasp convertible bonds well in the accounting world. My experience with blurring debt and equity is mostly with closely-held companies that would like to keep the IRS from requiring shareholders to recognize time-value income (aka interest) on loans they make to the company to make ends meet.
[…] liabilities. Bank deposits entitle the owner to on-demand access to fiat currency, backed by the balance sheet of the bank. Gold-backed sovereign currency entitles the bearer to settlement of tax liabilities […]
Regarding convertible notes, maybe this is of interest and maybe not:–
The main advantage of convertible notes in ‘angel investing’ is that – unlike preferred shares – you don’t have to set a valuation. You can leave that to later, when ‘professional’ investors come in with a Series A preferred round. The basis value for the convertible note as an investment is just however much cash was put in, assuming nothing about the value of the company, so it isn’t dependent upon any equity valuation. The note accrues interest (usually not actually paid out, just accrued), and is most often sweetened by some warrants to purchase common stock at the current founder/employee price (usually less than pennies at that stage since there is no reason to set it higher).
When the Series A (or Series Next if there is some history, cram down or whatever) happens later on the investor can either get his loan paid back (keeping the warrants) or can convert some or all of it into the purchase of Series Next preferred shares. At liquidity the preferred holders get their money back first (that’s the liquidation preference in ‘preferred’) usually with some participation (that is, more back than they put in). Then the whole preferred nut converts to common shares and participates in splitting the remainder of the pie with the common shareholders.
It sounds like a pretty sweet deal for the angel investor, but keep in mind that he’s risking real money on what is usually just some guys and an idea with maybe the beginning of a prototype product, at that point. So it is high risk and most of them fail, but the ones that succeed pay very well indeed.
So anyway, I tend to think of all investors – debt and equity – as a group, supplying capital under various terms; with the operating business as its own distinct thing. You can have a great operating business with a stupid capital structure or vice versa, so it is important to at least think about them separately.
Thanks Zippy – not immediately in my milieu, but helpful nonetheless.
[…] In the absence of usurious contracts, fractional reserve banking doesn’t ‘create money’: it securitizes property. To securitize property is just to issue title to some sort claim against that property. That is where every kind of currency gets any real value that it actually has: currencies entitle the bearer/owner to something other than the currency itself, and the value of that entitlement is the intrinsic value of the currency. When a non-usurious fractional reserve loan is made, the bank issues a new demand deposit account – a claim against its balance sheet – in exchange for a collateral interest in the (new, at least to the bank) property which collateralizes the loan. It would be similar if the bank had issued new stock in exchange for its claim against the new-to-the-bank property. The main difference is that a deposit account is a different kind of security from capital stock, with a different structure of claims against the bank’s balance sheet. […]
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