1. Like other legal framework questions in starting a company, one of the tricks is to build a legal structure which is ready to accommodate growth. As your company grows, if you have the right legal structure in place, you will have less legal work that you have to do along the way to keep up with the growth. (For example, authorize enough shares so that you don’t have to amend your charter later on to authorize more. Authorize blank check preferred so that you don’t have to amend your charter to close your first preferred stock financing, etc.)
2. Every startup entrepreneur is busy—really busy. There are business plans to write, projections to prepare, and products to design. In their earnest desire to get ahead, it’s easy to overlook the very issues that can slow down any fast-moving company.
3. A new corporation is formed when a Certificate of Incorporation in Delaware (or Articles of Incorporation in California and most other states) are filed with the Secretary of State
4. The authorized number of shares that goes in the Certificate of Incorporation is the number of shares that the Board of Directors may issue without amending the Certificate of Incorporation. By contrast to authorized shares, issued shares are shares that have actually been sold and are outstanding.
5. Amending the Certificate of Incorporation to increase the authorized number of shares requires a vote of the stockholders of the corporation. It also requires a state filing and associated fees. This is somewhat tedious. When thinking about the number of shares that you need to authorize, plan so that number of shares initially authorized is sufficient for your purposes for the foreseeable future, until a significant event in the life of the corporation, such as a financing, for example, when you will go through the trouble of amending the Certificate of Incorporation.
6. This is because a stockholder's share in a company is calculated as such stockholder's shares divided by the sum of all issued and outstanding shares of the company and the shares reserved under the company's stock plan. Note that a stockholder's share is not based on the company's authorized shares. Therefore, if a significant cushion exists, an investor's share can be easily diluted by the company issuing shares from the pool of authorized shares, without seeking the investor's consent.
7. For my startup clients, I typically recommend that 10,000,000 shares of Common Stock be initially authorized. There is no magic to this number, but it tends to result in a Series A price per share that is of a familiar/standard magnitude.
8. Typically, at a Series A stage, a startup is going to be valued between $2M and $12MM, broadly speaking. At the time of investment, the Series A price will be calculated as pre-money valuation divided by the total number of then issued and outstanding shares, plus the shares reserved under the company's stock plan (including an increase to the stock plan reserve for the Series A round). Simplistically, a $10MM pre-money valuation, divided by $10MM shares (which include shares already issued to the founding team and the unissued shares reserved under the stock plan), equals a Series A price of $1.00. Individual numbers will vary of course, but it makes it easy and convenient to stick to conventions, so that the Series A price per share isn't 1/100 of a dollar nor hundreds of dollars.
9. A typical startup uses the "assumed par value capital" method to calculate its Delaware franchise tax liability. The minimum tax that may be owed under the assumed par value capital method of calculation is $350.00
10. Total Gross Assets (as reported on the U.S. Form 1120, Schedule L) X (Authorized Shares / Issued Shares) X $0.00035.
11. A typical reserve, even without a formal stock plan, is 10-30% depending on the company's hiring plans. So, in our typical scenario, the founder or the founders would be issued, in the aggregate between 7M and 9M shares of Common Stock, with 1M to 3M authorized and unissued shares remaining available for future issuance.
12. Note that the share reserve needs to be sufficient for the company's hiring needs until the next time that the Certificate of Incorporation is amended, and as we've said before, a natural time for the Certificate of Incorporation to be amended is in connection with an equity financing.
14. If the issuance serves to increase the value of the company, your smaller piece of the pie might in fact have a higher value than the bigger piece of the smaller pie that you had before.
15. The example above demonstrates that what you should watch out for is not securities issuances which dilute your percentage interest, but securities issuances that decrease your total value. The latter are the instances where equity is being issued without a corresponding increase in the value of the company. Examples of those might be (a) warrants with a low exercise price that are issued as part of a loan transaction, (b) shares issued to investors at a discount or a price lower than the company's last valuation, or (c) shares issued to employees.
16. As disappointing as this may be for founders and other holders of common stock to hear, really the only equity holders who ever get antidilution protection are the investors (holders of preferred stock).
17. It may not seem fair to someone who has earned his sweat equity with... well, sweat and hard work. But investors are the ones that pay the full market price for their shares (usually 3x or more the price of Common Stock), and they are the ones who are more typically able to successfully negotiate some protection for themselves.
18. However, they will get an adjustment (the conversion rate at which they Preferred Stock converts into Common Stock will increase, such that the same number of Preferred shares will be convertible into more shares of Common Stock) for issuances made at a price below their entry point, with certain exceptions. The list of exceptions to investors' antidilution protection is frequently the subject to heavy negotiation between company and investors' counsel.
19. Founders Stock Refers to Common Stock Issued to Founders with Certain Characteristics; Namely, Founders Stock is Normally Issued at Par Value with a Vesting Schedule.
20. The term “founder” and “founders stock” are not legal terms, rather, they are terms of art describing a certain class of early participants of a company and their ownership interests. You will not find the terms “founder” or “founders stock” defined in the corporations code.
21. “Founders” of companies fall into the class of initial stockholder (certainly), director (probably) and officer (probably). The founders put together the initial plan; they are the people who decide to make the leap from idea to project to forming a new corporation, and that is when they receive “founders stock”. Companies that do not exist cannot issue founders stock.
22. Founders stock means the shares of common stock stock that are issued in the organizational minutes or consent of the board of directors of the company when they are setting up the new business, adopting bylaws and appointing officers. This is called “organizing” the corporation. The people who get this initial stock are the “founders” as a general rule.
23. It’s important to look at the characteristics of “founders stock” as well. It will generally be a large percentage of stock to each individual founder (larger than they would ever receive joining a more mature company). The founders stock is normally issued at a nominal price, often times the par value of the stock, such as $0.001 per share, a very low number. The company can issue founders stock at a low price because it hasn’t started to do any business yet, and so the new corporation is essentially worthless. The equity upside of owning the founders stock is likely to be the only initial compensation for the founder, and, if the company does it right, the founders stock is subject to vesting contingent upon the continued provision of services to the company (stock issued subject to a vesting schedule is called “restricted stock”. The company buys back unvested founders stock at cost if a founder’s service to the company is terminated for any reason).
24. After incorporation new team members can get stock with these characteristics and are sometimes called “founders”, but issuing stock at a very low price after the company has done anything to build value (built a prototype, gotten some users or customers, first revenue) can lead to income taxes for the founder getting “cheap stock.” Because of this, after incorporation companies normally increase the stock price, close the class of “founders stock” and issue options instead going forward.
25. Vesting of shares and stock options is the preferred method of providing incentive to build a team and keep it motivated. It is also the method for protecting the company and the other stockholders when someone quits or is fired and produces better results than a buy/sell agreement.
26. If the shares issued to a stockholder will have vesting provisions, the stock is called “restricted stock”, meaning stock issued with a vesting schedule.
27. Vesting is very important to protect the initial stockholders of the corporation, called the “founders”, from each other.
28. When a stockholder quits working for a startup company and takes a large chunk of equity with him or her, it can be very demoralizing for the remaining stockholders who continue to work for the corporation in order to build stockholder equity. Vesting is the mechanism that guards against that happening.
29. Vesting is preferred over a traditional “Buy/Sell Agreement” for startup companies. In a typical Buy/Sell Agreement, if a founder stops providing services to the company, the corporation and/or other stockholders have a right to buy out the departing stockholder at a purchase price equal to the fair market value of the departing stockholder’s stock.
30. A vesting “cliff” means that there is a period of time of no vesting, but when the specified time (the “cliff”) is hit, the benefit becomes fully vested. For example, in a 48 month vesting schedule with a 12 month “cliff”, no vesting occurs for the first 12 months, but at the 12-month point the stockholder receives full credit for 12 months of vesting. After the “cliff” is met, vesting would continue thereafter on a monthly basis. A “cliff” is often used with new employees. It acts as a probationary period during which the new employee has to prove himself or herself.
31. The vesting provisions in our Restricted Stock Purchase Agreement contains a clause that all unvested shares will vest in full on an accelerated basis upon a sale of the corporation. This agreement is intended to be used for founders of startup companies and is also included in our Incorporation Premium Legal Documents Package for as many founders that will be issued restricted stock.
32. Par Value is an anachronistic concept from corporate law, but it’s still there to cause headaches
33. Par value is the minimum issue price for a share of stock. It is always best to use a low par value, even though no par value stock is allowed. The selection of par value will oftentimes be based on how much the founders plan to invest to initially capitalize the corporation.
34. For a pure startup that has yet to do any business, the shares are essentially worthless and so are are most often issued at par value. A par value quite often used is $0.001 per share.
35. No par value stock, while allowed, is a trap for the unwary: it can likely lead to much higher Delaware franchise taxes because companies with no par value stock will be taxed automatically using the Delaware Authorized Shares Method. If the corporation authorizes 10,000,000 shares, the tax using the Authorized Shares method would be in excess of $50,000-an absurd number.
36. Delaware Authorized Shares Method vs Delaware Assumed Par Value Capital Method
37. Using the Delaware Assumed Par Value Capital Method, the minimum annual Delaware franchise tax will be $350.
38. “Authorized but unissued shares” are shares that are authorized but not issued. In the example just given, a company with 10 million shares authorized, but only 2 million shares issued, the “authorized but unissued shares” would be 8 million
39. Why would you authorize more than you might issue? Because you want head room. You want the shares available in case you need to issue them.
40. Don’t be afraid to have headroom for future growth.
41. The corporation shall be designed for scalability, etc.
42.
References:
http://startupvoice.blogspot.com/2013/06/getting-to-reasonable-cap-table-how.html
http://startupvoice.blogspot.com/search/label/dilution
http://blog.venturedocs.com/2013/05/what-is-founders-stock-legally/
http://blog.venturedocs.com/2013/02/par-value-a-trap-for-the-unwary/
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