The company is set up, shares authorized – How many shares should be issued to Founders?
Once you set up your company, you should think of issuing shares to founders. You typically issue 50-80% of the authorized shares of common stock to the founders. The Articles of Incorporation usually authorizes 10,000,000 shares of Common Stock, an aggregate of 5,000,000 to 8,000,000 shares should be issued at incorporation. Please remember, you will also need to reserve some shares for employees by creating Employees Stock Options. If you are short on authorized shares, your company will have to file a certificate of amendment with the Secretary of State (SoS) and pay the required filing fees associated with it.
Classes of Shares
There are usually two classes of corporate stock; common stock and preferred stock. Common stocks are usually issued to founders and employees.
Most companies only ever have one class of shares. The class of shares are usually recognized as ordinary shares. Ordinary shares represent the company’s basic voting rights and reflect the equity ownership of a company. Founders and employees are usually holders of Common Stocks.
Preferred stockholders are promised a certain amount of dividends (cash) each year. They usually do not have voting rights. Preferred stock shareholders usually do not participate in electing the corporation’s board of directors or vote on other critical issues facing the corporation. Investors are usually receivers in exchange of investment (usually cash).
How do I set aside employees shares?
Once your company is set up you automatically have authorized company shares. We can presume that you have authorized 10,000,000 shares. These shares can be issued to the future shareholders. It is common to reserve shares for your employees. An option pool consists of shares of stock reserved for employees of a private company. This is the perfect way to attract more skilled employees. Start-ups usually reserve between 10 and 20% of the company’s equity for the option pool. Once you issue shares to founders, you can set aside shares for the employees.
First, you need to reserve shares for equity class. The equity class creates pools of shares which cannot be moved, there are considered to be issued to employees.
How do I authorize or issue shares?
Shares Authorization happens once you set up your company. The Incorporator states the number of authorized shares on the Articles of Incorporation (Certificate of Incorporation).
Then you reserve shares for the particular equity class e.g. founders, employees & investors.
Once the class is created, you issue shares to each member of the class. Technically you simply add a shareholder to the class by issuing shares to his or her name.
How do I divide equity among founders?
Maybe 50/50 Is Not Such a Great Idea. Co-founders should divide equity according to the value they create for the start-up. Before you do any math and start cutting the pie, make sure that you sit down and have a constructive meeting on how to divide the shares. There is always who contributes more than the other person. It is purely your decision to make; however, use some of the Co-Founder Equity Calculator to determine the percentage among the founders. There are many variables which have different weights, based on this calculation, you can come up with a valid solution on the founder’s ownership.
Dividing equity within the Company
The usual structure of any start-ups consist of founders, investors (or advisors, lawyers, third party in general) and employees. Please, consider this as an example or starting point for a discussion.
Before Pre-seed or Seed Round Investment
- Founders 50 % – 80 %
- Option Pool 10 % – 20%
- Employees Stock Option 10 % – 20%
After Pre-seed or Seed Round Investment
- Founders 50 % – 70 %
- Employees Stock Option 10 % – 20%
- Option Pool 10 % – 20%
- Investors 10 % – 20%
Note: All these numbers are flexible
If you are considering any split among the founders, make sure that everyone gets his/her stake in the company based on the participation. This is very important as this makes the company stable in hard times. 10 million issued shares? It is a brilliant idea but it might cause higher franchise fee with the Secretary of State (make sure that you don’t issue all shares so you are safe and low-cost). You can always allocate unissued shares in the future without having to incur a legal bill to authorize more shares.
Common vs. Preferred Shares
What is the difference between Common vs Preferred Shares?
Holders of Common Shares have voting preferences whereas Holders of Preferred Shares don’t have voting preferences. Both of the shares represent ownership in the company.
- Common shares are usually issued to Company Founders and Employees (Founders usually decides to create Employees Stocks Option Pool (ESO).
- Preferred stock are usually issued to Investors. Dividends are often higher than common stock dividends. Preferred stockholders have a greater claim to a company’s assets and earnings. Preferred stockholders must be paid before common stockholders. Order Paid if Company Defaults; Debt-holders are paid first, Preferred second and Common third. Companies use preferred stocks to raise capital for growth. Preferred are usually issued after the Common stock (to Founders and ESO). Common don’t always receive dividends. Preferred always receive dividends.
How preferred stock affects the value of your equity?
- Liquidation preference – preferred stockholders have a right to get their money (based on the investment) back before anyone else. Preferences are mostly expressed as a multiple of invested capital. If preferred stock has a “1x” liquidation preference, then preferred shareholders are entitled to receive an amount equal to one time their investment before other shareholders receive anything. This action might happen only in case the company is changing the structure of the overall ownership and the current shareholders are selling their shares. The holders of the Preferred shares get paid first.
- Participation Rights – shareholders participation rights are calculated as a pro rata in the remaining amount. An investor is entitled to any value leftover post-liquidation- that is if that stock had been common stock.
- Participation Cap – Participation Cap is limited by the amount of proceeds an investor can receive from participation rights. : After dividend has been paid to the equity shareholders, holders of participating preference shares have the right to participate in the remaining profits. However, the cap stipulates the limit.
Why do we need different valuations? Common and Preferred shares are valued differently?
Investors purchase a class of stock known as Preferred. The post money valuation is based on what an investor is willing to pay and what the company is willing to sell shares for. It is an arrangement between the company (Founders) and the investor or group of investors.
409A valuation is for a class of stock known as Common (a 409A valuation estimates the fair market price of common stock), which is what founders have, and employees have options on. In theory the market price of common and preferred stock should converge as a company gets into a later stage.
Why is a company valued so differently between its post-money investment valuation and its subsequent 409A valuation?
Investors purchased a class of stock known as Convertible Preferred, and the 409A valuation is for a class of stock known as Common, which is what founders have, and employees have options on. The difference in common shares price estimated by 409a (setting up the strike price for employees or grands) vs. preferred shares value – valued by investment, ratio is 1:3. The investment valuation for the Preferred can be anywhere from 2x to 10x that of the 409A valuation of the Common, which is why the company needs to get an objective, external 409A valuation every year.