Is Startup Financing for Founders a Big Deal? Can Be.

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There has been quite a bit of chatter over the last couple years about a tech bubble -- increasing hype which drives increasing valuations and increasing funding rounds beyond what the companies are actually worth.  This article is a natural reaction to that.  In it, the author questions whether funding announcements are actually a mark of success or of failure:

"I'm concerned a little bit with the culture of celebrating the fundraise," he said. "My dad taught me that when you borrow money it's the worst day of your life. We didn't clap for Red Rover [who spent time raising revenue instead of funds] because they didn't raise $6 trillion, but I was sitting here like, 'Good stuff!'"

Clearly, building revenue is the goal of any startup.  But we mustn't overlook the fact that funding in this environment matters for two reasons: validation and expertise.  To a certain extent, receiving a funding round from either an investor or a syndicate of investors gives some credibility and visibility to a startup by saying, "Hey, we like your business model and think it has a chance to succeed."  As they say, success begets success; scoring a financing round from serious investors is like a badge of honor that can be used to grow and raise additional funds.  It is not a guarantee of success, but it certainly helps.

But even more important, investors will take an active role in the company to protect their investment, which can be both good and bad for founders.  The bad side is giving up a chunk of equity ownership and control of the company, but the good side is that you now have an experienced partner to add to your team.

That being said, it can certainly be a two-edged sword.  The effectiveness of your relationship and the quality of that guidance is only as good as your new investor partner. I know of horror stories of investor relationships that sour and cause headaches (or worse) for founders.  But under the right circumstances, investor funding is an infusion of credibility and guidance, in addition to the capital, and that, indeed, can be something to celebrate.

Authorized or Outstanding Stock: What Percentage Does a Startup Founder Own?

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Here are two questions that I get often.  Should the founders of a startup company divvy up all of the stock?  If not, how do I calculate ownership percentage?  In order to answer these, we have to review the difference between authorized shares and outstanding shares. At formation, a company must state the number of total shares that are authorized under its charter document (the name of the charter will vary by state but will be called Articles of Organization, Certificate of Formation, or something similar).  This is the "bank account" of stock for the company and represents the maximum number of shares that stockholders can own.  Once you give out this stock, you need to amend the charter before you can issue any more. However, the authorized shares do not represent ownership in the company (see below).

The authorized number is different from the issued stock.  The issued (or "outstanding") shares have actually been given to stockholders.

The ownership percentage of a company is calculated entirely by the issued shares.  Say, for example, your company authorized 10,000,000 shares and issued 1,000,000 shares to each of two founders (a total of 2,000,000 outstanding shares).  That means that the two founders each own half of the outstanding shares or 50% of the company, and there are still 8,000,000 shares to issue.

If the company then issues 500,000 shares to third founder, then the ownership percentages change based on the new outstanding number (2,500,000).  Therefore each 1,000,000 to the first two founders now represents 40% of the company and the third founder now owns 20%.

Generally, a company wants the number of issued shares to be fewer than the number of authorized shares because a company will want to leave some shares in the "bank account" to issue at a later time without having to update its charter.  However, the number of authorized shares and the number of issued shares is arbitrary; in the above examples you could cut all of the numbers in half or by a third and the percentages would work out the same.

This gets a bit more complicated when you add in stock options, which are contracts given to holders for the right in the future to buy shares at a certain price.  Even though the stock option shares are not issued until the option is exercised, the company still needs to reserve that number of shares so it doesn't go over the total authorized number.  So before the options are exercised, the actual ownership percentages stay the same (because the shares have yet not been issued).  But the company may then refer to its "fully diluted" ownership, which means the ownership percentages as they would be adjusted assuming that all of the options get exercised.

The Most Important Questions for Co-Founders

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Startups often struggle because of how they are set up.  Too often founders will treat a new company like a budding relationship: you get all excited about your idea, you seem to agree on everything, and then you move in together.  Relationships built on that kind of whirlwind courtship often end up in failure, and startups are no different. It is critically important for co-founders to have the detailed conversations about their business, their working relationship, and many other topics that they will have to deal with as the company grows.  In fact, we have discussed this here on a few occasions (see Founders Series Parts I, II, and III.

One of the people who knows this best is Dharmesh Shah, successful entrepreneur and c0-founder of HubSpot.  He recently published a list of the most important questions that co-founders need to resolve as soon as possible when starting a new business.  If you are in the process of starting a business, stop what you are doing and read it.

This First Thing Every Founder Should Purchase

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What is the first thing a new startup company should purchase? Right, a hat rack. Wait, what?  You need one because each founder is going to be wearing several hats - organizationally speaking - and it is important to keep the various roles separate. Here is why. I was recently working with a client who is splitting off from a business he started with a partner, taking some of the assets from their company, and putting those assets into a new company in which he is the sole stockholder. As an exiting founder of the old company and the sole founder of the new one, he is taking on several different responsibilities, including as a stockholder, director, and even lender. This is legally significant, even if he does (inaccurately) refer to "my company" or "my equipment".

But when talking about roles, first understand that that I am not talking about titles. The titles that companies often hand out early on have less to do with the business than they do for establishing some sort of status hierarchy. Some state laws even necessitate designations like president, treasurer, and secretary - Massachusetts is an example - but don't get bogged down in titles. The law dictates legal distinctions between stockholders and directors, but don't try to pigeonhole your team into arbitrary titles that don't fit your organization.  Let the work dictate what roles and responsibilities to assign to management.

Why does this matter, you ask? There are several reasons:

  1. Title to property. New founders often erroneously treat company property as personal property. This has ramifications both from a practical standpoint (who owns the property that he wants to take to the next venture) and legal significance (can the company collateralize the property for lenders). If the exiting founder wants to take certain property with him, it is already tied up by a security interest under the company's bank debt? Did the company pay for the equipment or was it using property belonging to its stockholders? Those questions become all the more important when a change of ownership takes place.
  2. Organizational confusion. It is critical to sort out the rights and responsibilities of the organization - who has the ultimate control and authority? Often, a pair of founders will split these management roles equally (see my earlier post on why that may not be the best idea), but that effectively means that every decision requires unanimous agreement. Many important decisions have to get made on a daily basis; without proper role assignment, decision-making can get bogged down or actions may be taken without authority or notice. Even worse, an organization may not understand who is responsible for making key decisions.  Not only does this create problems within an organization, but it could also raise red flags to future investors.
  3. Legal risk. there are also significant legal ramifications should the rights and responsibilities of the owners and managers get muddled. While state law protects owners from personal liability for corporate obligations, a court may sometimes "pierce the corporate veil" and assign personal liability where owners of a company did not maintain the "separateness" of the entity.  Blurring the lines between corporate and personal increases that risk, as does lax handling of roles. It may seem odd for a stockholder to elect a director who authorizes the company to take debt from a lender when each of those is the same person.  But maintaining those distinct roles will help protect you from liability and confusion.

So where does all of that leave business owners? From the start of your business, choose a structure that fits with your business and keep straight what actions you take as a stockholder versus the actions you take as a director.  Then clearly allocate management responsibilities between the founders and the rest of the team and make sure that structure is clear to the rest of the organization. Because your decisions not only have ramifications for the company, but also may directly impact your personal bottom line.