How to issue shares in a startup?
This article will cover all about a startup equity structure and how to issue shares in a startup.
Share equity in a startup is one of the main things owners struggle with. Most startups often tend to deal with this at the last moment after other things are dealt with. But if you are a founder or an owner who is getting stressed about the division of the shares, relax.
While dealing with share equity of your company, the main thing to focus on is to make sure the rest of the way is smooth and does not cause problems in your equity structure. This article will cover all about a startup equity structure and how to issue shares in a startup.
Structuring a Startup
Looking at the basics of structuring equity, you will have to deal with the main people involved. They are founders, investors, advisors and employees. Now you might be wondering if it is the same for other companies? In reality it varies, and there are companies that do not offer equity to investors and others that don’t offer it to advisors. Based on your needs, you can issue shares in your startup.
Here are the different kinds of equity structures you can have in your startup:
Equity structure of a startup
Determining the equity for founders in the right proportion is essential. So, how do you make sure everyone is happy when you allocate shares in a startup? The easy way about this is to divide it equally among the owners as it helps avoid any future conflict. But a lot of companies do not follow this as some owners contribute more than others. This can be in money, time or even effort. In such a case, you can determine the startup equity split is by figuring out the portion they get based on their contribution and how much it is worth. This is sometimes referred to as Sweat Equity.
The main issue that arises with this method is that the proportions are determined based on feelings and rough predictions of the future worth of the company. Which in most of the cases, the predictions are generally wrong or not close to what they determined. Companies that go this way spend time in the future renegotiating the portions and that’s not good for the company and the owners as there could be clashes between interests.
It is not easy to issue shares in a startup; but if the startup equity structure is created properly, it will benefit the company in the long term. The best way to split is using a method called slicing pie, where you split the portions based on your investment in the company. For example, if one owner is willing to invest $3 and the other stays on $1, then the split percentage of the proceeds in the future should be at the ratio of 3:1. This scenario is the best as it is fair for both owners.
Equity for advisors
In a startup, advisors are an essential part as they have the knowledge and experience of doing what you are attempting to do. Oftentimes, their advice is invaluable to the company as it helps reach greater heights. There are no firm guidelines to follow while issuing shares in a startup to advisors, but the most basic percentage is 0.5 to 1. The various factors to consider while doing so is the advisor’s experience, knowledge, and time at which he/she joined the company.
There are two types of advisors: formal and personal. Formal advisors are generally those who provide strategic perception in the business and personal advisors give specific tactics to follow on bumpy occasions. Generally, companies give formal advisors a percentage of the share but do not do the same to personal advisors. But depending on the insight, personal advisors too can get equity.
The other way to go about compensating advisors is through a FAST agreement. A Founder Advisor Standard Template (FAST) agreement is a contract that engages a person to act as an advisor. In this agreement, the advisor is not obliged to compensation in cash. Instead, in the future, they have the right to receive shares of the company. Under this, the person is not an employee but an independent consultant.
Equity for investors
While allocating shares in a startup, there are different categories of investors such as angels, venture capitalist, and others, and all of these have to be considered. Usually, it’s fair that investors get a higher share of the equity when compared to the employees and the advisors. This is because they are the ones with more at stake in the startup. Their contribution is the one that helps kickstart the business. For bearing the risks of loss, they expect a higher stake in the company. The main way to determine the percentage of equity they receive is by looking into the amount they invest and the value of the business they invest in.
The least used way is by conversing with investors and negotiating the share of equity you are willing to offer. One main factor that affects the offer you give is the valuation of your company. As a newly found businessman, the best method to assess the potential valuation of your company is by talking to founders or businessmen who run companies similar to yours. Once you have a rough idea you can go ahead and negotiate an offer. Work out a deal that both of you are comfortable with.
Equity for employees
Startups initially do not make enough money to pay their employees a part of or the entire salary. When you are not able to pay an employee salary at the market rate, there is a less chance that the employee stays motivated to stay at your company. Any why wouldn’t they change? The best way to offer benefits to your employees is if you issue shares in a startup to them. This would help them stay interested and even work harder to increase the value of the company. But there are a lot of startups that do not offer these benefits to the employees as they see the disadvantages that come with it.
The two main disadvantages include the complexity that it brings and the high tax that the employee has to pay for getting the shares as compensation. In fact, if you offer a new employee with shares as soon as they join, they might have to pay for it which might not be possible for them due to the lack of cash. This too can make them leave your company.
Authorized vs Issued Shares
Authorized shares refers to the maximum number of shares legally allowed to be issued versus the stock that is authorised in an organization. Out of the authorised shares, issued shares are those that are issued in the market for public trading. In a private company, it is the number of shares issued to investors, advisors and so on. The number of shares listed in the article of incorporation is the authorized shares. And it is the total number of shares the corporation is allowed to issue. Issued shares can not cross the number of shares authorised.
How to increase the authorized shares in a startup?
The only time authorized shares can be increased is when the majority of the shareholders vote for this change. A meeting with the shareholders can be done at any time without any limiting timeframe regarding when it can be changed. Companies usually tend to keep their issued shares lower than their authorized shares to maintain a certain flexibility. But in case the authorized shares are less and the company needs more to issue, you can get them increased.
There are different ways to increase the number of shares, including:
- A stock payment
- Exercising a warrant or an option
- An IPO (initial public offering)
- Private placement while Issuing Shares
- Secondary offering
Other than this, the company can also buy back shares from other investors in the company. These shares are then added to the treasury stock. Treasury stock is when the outstanding shares decline, and this occurs when a company buys back their shares. But if buying is not an option, then you can use the other options mentioned above to have the shares increased in the company.
What is a stock dilution?
Also known as equity dilution, stock dilution is the fall in the percentage ownership of existing shareholders. This happens when the company issues new equity. When new equity is issued, the existing shareholders’ ownership gets diluted due to the increase in the total shares outstanding.
Let us take an example to understand this better. At the beginning when X Inc was formed, they authorized 100,000 shares as common stock from which 80,000 of these shares were issued. To break it down, about 40,000 shares were issued to founder A and 40,000 to founder B. Each of them owned 50% of the company, which was 40,000 out of 80,000 shares.
Now, let us say that a new investor comes into the picture and the company decides to issue 20,000 more shares. This would make the ownership of both the owners fall to 40%. It is because the total outstanding shares are now 100,000 and each of them own just 40,000 each. And just like this, the stock dilution takes place when more shares are issued in the startup equity structure.
Checklist for Issuing Shares in a Startup
From the above it is understood that you need to be careful when you issue shares in a startup. Although issuing shares offers a lot of benefits, it can also cause a lot of issues for you if not done properly. So, before you issue shares in your startup, you should follow this checklist:
#1 Board approval and Shareholder approval
The approval of the BOD, as it is important to get the board of directors consent for the sale of the stocks. In fact, the board’s approval is needed for the filing of any government documents and any agreements for the sale of shares in the company. You can go about this in a board meeting and get votes from the members. Moreover, if you are amending the AOI by raising the number of authorized shares to issue them further, you will need the approval by the majority of shareholders through a meeting or written consent.
#2 Review compliance with securities law
Reviewing the Article of Incorporation and following the rules of the government is essential especially when you want to issue more shares. You need to check if you have the number of shares that you want to issue. Proper steps need to be taken to make sure you adhere to the federal and state securities laws before you offer or sell stock in the state where your company has been incorporated.
#3 Prepare appropriate agreements
The documentation of the sale of stock is important. When common stock is sold to friends and family and the transaction is not negotiated in the appropriate way, it can cause issues for you when you are about to sell the company or wind it up. It is important to give the share certificate or the subscription agreement when giving out stock. This agreement is normally signed by the authority of the company and approved by the board as well. It is also important since it lists all the information about the share you are giving out along with the rights that come with it.
#4 Create a vesting schedule
For many cases, it is always good to have a vesting schedule in place. This would help you stay safe as a vesting schedule doesn’t allow the person to take the shares and leave the company immediately. This works best for the founders, employees, and advisors. Vesting schedules are not added to the issuance of shares for an investor since they are paying the company funds that would help it grow.
Let’s take an example to understand a vesting schedule. Assuming there was a company named My Services Inc who needs an expert advisor for the company. The company finds Nina who is a great advisor but the salary package she wants isn’t something the company can afford. In this case, they make a deal with Nina and offer her equity compensation. She would be getting about 1,000 shares as equity over a 4 year period. This vesting schedule is in place so she doesn’t leave immediately after getting the equity.
The vesting schedule is a time-based vesting schedule over 4 years with a 1 year cliff. This meant that Nina would get 25% of the total shares after one year of staying with the company, and 25% every year for the next 3 years.
The vesting schedule would look like this:
|Time Period (Year)||Percentage of Vested Shares||Number of Vested Shares|
If Nina decides to leave in between, the shares she received would be forfeited and she would not get any compensation. This is what a vesting schedule is about. It makes sure that the employee/person sticks with the company for at least a period of time before they can leave and benefit from their equity ownership.
#5 Price and number of share
The number of shares to be issued and the price at which it should be issued should be determined. The result of issuing new shares will be the dilution of existing shareholders ownership, and this needs to be thoroughly reviewed and deemed acceptable before issuing.
#6 Make security law filings
While you issue shares in your startup, generally within 15 days of the sale of stocks, fillings are required with the SEC (Securities Exchange Commission) or the state administration for securities. So, make sure you do the filing on time.
#7 Issue stock certificate
Immediately after the stock is sold, the organisation must issue a stock certificate. Also, make sure each of those certificates are numbered, signed, and dated by the appropriate officers in the organisation. It is best for the company records that you make a copy of each stock certificate. Or another way out is by issuing electronic stock certificates using an application like Eqvista where you would not have to waste paper and would also have a record of all the certificates in one place.
#8 Record the stock transactions
It is a must that within your organisation’s stock ledger you record the issuance of stock. While doing so, make sure it shows the name, stock certificate number, address of each shareholder, the paid consideration, and other relevant information.
How can Eqvista help you?
In short, when you open your startup and work on the startup equity structure, you need to keep track of all the shares in your company. This would help you know where the shares are, who owns how much and how much dilution takes place due to an issuance. Without the record, you will end up issuing shares without knowing how much ownership you are giving away, which will cause stock dilution.
Eqvista is a cap table application that allows you to track, manage and record all your company equity. All the transactions are recorded in real time and the updates as well. You can also share the cap table with your lawyers and accountant. The app also allows you to create a board of approval resolution, which means voting on board motions all in one place. So, what are you waiting for? Try it out today!