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

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 Ghost of Par Value and its Real Effect on Startup Businesses

Par value is one of those legal mysteries involved in forming a business that entrepreneurs have never heard of and ten minutes after incorporation, may never consider again.  However, I ran into a situation recently where it mattered to one startup company (at least for a moment). For a quick bit of history, par value is an anachronistic concept where the company sets a stated value on each share of stock it authorizes.  States allow that par value to be any any amount, but typically it is set at zero or some very small value.  In the past, this amount had legal effect and represented that amount that was originally paid for the stock and made up the initial capital of the company.  However, now, it has little import aside from some minor accounting issues and calculating state taxes in some states (like Delaware).

I am working with a startup that was incorporated in Massachusetts and is now considering a reincorporation in Delaware.  The  founders originally choose to have "no par value" as is permitted in Massachusetts and did not give another thought to it because of what I stated above and because annual fees for corporations in Massachusetts are not based on par value.

When reincorporating in Delaware, the founders increased the number of shares (to provide some flexibility with investors and with employee equity plans) and assumed that the company would use the same no par value stock.  But in Delaware, there are two methods for calculating the franchise taxes that the company must pay every year.  Without going into the particulars of each of the calculations (because you would fall asleep on your keyboard), the franchise tax with stock at a par value of $0.01 per share resulted in an annual franchise tax of $350.00 whereas the same amount of stock with no par value could result in a franchise tax of $75,075!

The bottom line. In thinking of par value, do not think any more than this: just go with par value of $0.01 or less and don't think about it again.

Best of Both Worlds: Converting Your Startup From a LLC to a Corporation

Entrepreneurs often ask my opinion on which type of entity is best for a startup or small business and, while I have written about this before, I generally say that one size never fits all.  That choice is made by each company depending on founder structures, short- and long-term planning, and, of course, tax.  I have seen companies start as corporations and as LLCs and both can be successful depending on your circumstance.  But are you stuck with that form once you make that choice?  That requires a bit of explanation. C-Corporations as Default? Many lawyers and entrepreneurs will tell you that all new startups must be Delaware corporations, and more explicitly, C-corporations.  This is the result of a common view that Delaware law is more friendly to your business than your state's, the courts are specialized and prepared to deal with business law issues that your company may face, and that a C-corporation is the structure that you will need in the event you take on investors (which you will certainly need if you are going to be taken seriously).

Without rehashing my previous post, I don't automatically subscribe to that line of thinking.  There are some startups that have very valid reasons for starting as, say, a limited liability company.  Those are mostly attributable to the flow-through tax structure and the flexibility of management and with allocations and distributions to the members. In other words, a company can take advantage of the tax savings of not having to pay corporate tax like a C-corporation during the early years of operation, the flexibility of adjusting the amount of distributions it gives to its members, and the freedom to customize management and ownership structures.

Can you Change your Entity? And if your LLC needs to be corporation later in life - for, say, investment or tax reasons - state laws provide mechanisms that vary by state for conversion from a LLC to a corporation (note: converting from a corporation to a LLC results in a much different, and less favorable tax treatment).  In Delaware, it is as simple as filing a conversion form.  In other states, such as Massachusetts, the same thing is accomplished through a somewhat more complicated conversion process or by enacting a full merger of your company into a newly-created Delaware entity.

What's it Going to Cost? Yes, there are both legal fees and filing fees associated with this type of conversion that will dissuade some companies from going down this route.  Your company needs to weigh the savings of flow-through tax treatment it will enjoy as a LLC with the cost of going through the conversion later.  And in addition to the legal fees, there are certainly some additional tax issues to consider (there we go again with the tax issues) particularly if you have passive members or hold certain types of debt.  But for many small and growing companies, you could accomplish a conversion without breaking the bank.  The key will be to make sure that your lawyer and accountant are involved early in the process.

Have you converted?  What was your experience?

Founder Series Part III: How to Structure and Document Your Founder Agreement

You should never start a venture without thinking about how to end it.  Many founders make the mistake at the company's formation of slicing up the founders pie, serving everybody a piece, and treating that as the end.  In this case, it needs to be the beginning.  Here's why and what you need to do to protect yourself. Now that you have carved up the equity, you need to decide what to do with it.  Even though on day one your team is in place, your roles are assigned, and you are ready to develop your company, remember that the only constant is that the situation will change.  You will hit some roadblocks with your business plan and have to evolve your concept.  You will have to prepare for those events that you don't expect.  And you may even have to adjust your founder team by adding or removing members.  Keeping your structure flexible will prevent headaches (and money!) down the road.

First, you should have a agreement among the founders (and write it down!) to deal with these issues.  Use the structure up front to prevent disputes later.  And, as I have noted before, you have to deal with both the economic issues and the management matters.

1. Equity Split and Ownership.  The discussion in the previous posts should give you a sense of why this is important to make clear up front, so I won't rehash that discussion.  But an important point in the Founder Agreement is to avoid using percentages to describe a founder's ownership.  Even though we often speak of percentages (as I am doing here for the most part) as a type of shorthand, the agreement should use specific numbers of shares of stock to avoid both legal and financial impacts down the line.  For example, if each of three founders has one-third of the company in the agreement, what happens when an investor is brought in or an employee is granted equity?  They need to be diluted to a certain extent to allow for the new stockholder.  This becomes even more important when someone leaves the company.  I once saw an owner claim an absolute right to keep 10% of a company because that was how it was stated in the agreement.  That will become unsustainable as your company grows.
2. Vesting and Restricted Stock.  Remember that once you issue stock to a founder, it belongs to them and your options become limited if you want it back.  So vesting of the stock (giving the founders full ownership rights to their shares over time) becomes a valuable tool.  If three founders split the company in thirds and then, after six months, one of them leaves the company, their ongoing ownership should reflect that.  This is often done through "restricted stock", by which the company issues stock to the founders in accordance with the splits they devised, but that stock includes a right for the company to repurchase some or all of it at a very low price should that founder leave the company (for whatever reason) - a right that will slowly lapse over time.  Typically, that is done over a three- to four-year period (anything more does not really make sense for a startup), and can also include some acceleration up front or upon certain events.  Now if that founder leaves the company, she can keep what she earned in the time she was there, but the company can buy back whatever has not vested.  This leaves the other founders with a stake in the company that will better reflect their ongoing contributions. PLEASE NOTE: A discussion on restricted stock is never complete without mentioning 83(b) elections.  I will leave the details to another post, but don't even think about taking restricted stock without considering the 83(b) election because 30 days after the stock grant, you lose the option and it may cost you thousands of dollars in taxes in the future.
3. Limits on Stock Transfers.  Founders choose to start a venture together because they bring unique qualities or because they have other relationship ties.  So you will likely want to have place some restrictions on when the founders can sell their shares (and thereby giving some or all of their rights to someone else) and to whom.  You could do it with an absolute ban on transfers without the consent of the other founders. But you can achieve more flexibility by adding a "right of first refusal" for the company or the other founders to buy the shares on the same terms, or a "tag along right" to give the other founders the right to sell some of their shares on the same terms.  A sticker situation develops when a founder dies or develops a disability that prevents participation in the company.  Since stock in a company is a personal asset, those shares will pass on death through a founder's estate.  So you may now be in business with that founder's spouse, kids, or someone else.  Consider including a buy-back provision at some predetermined price or calculation, or some other mechanism for transferring the shares.  Also, if you have a repurchase provision upon a "disability", you must take great care in determining exactly when that provision is triggered.  But in either a death or disability, it is wise to consider how you will fund the repurchase by the company or the cross-purchase by the other founders, which is typically done with proceeds from life insurance policies on the lives of the founders.
4. Management.  Generally, the ultimate control of the company rests with the stockholders through the Board of Directors and is tied to their ownership percentages.  However, a company with founders shares split up evenly is ripe for deadlock and disputes.  Founder agreements often address this with provisions dealing with how to elect directors, who should sit on the Board, and how will voting happen.  Do each of the founders get Board seats?  If not, then who?  What about independent directors?  Beyond the Board, agreements will also often include overriding provisions for certain events and decisions.  Even if the Board has the power to determine most of the daily issues of the company, all of the stockholders together may want to retain control if the company is issuing new stock, taking on debt, making capital purchases, and other major events.  These issues may be particularly relevant to founders with less equity than the others.  These "minority interests" may need extra protection because they will have little control on their own.
5. Intellectual Property.  Many startups have few assets more valuable than their intellectual property - whether it's comprised of software, patents, trademarks, designs, formulas, etc.  Having each founder contribute to the company any intellectual property she may have developed prior to formation is critical, but keeping control of the intellectual property that is developed over time can also prevent problems in the future.  I once saw a company's public offering fall apart when they determined that the intellectual property that served as the basis for the company's value was not properly owned by the company.  So sloppiness in this area can have profound effects.  The founders can also decide in this agreement what should happen with the intellectual property if the company is dissolved.  Even though the business may have failed, the intellectual property can be very valuable going forward.

The bottom line is that founders need to spend some quality time working through these issues.  As I mentioned in the previous post, the process can be quite uncomfortable with founders focusing on what happens when things go wrong.  However, nothing will ever go as originally planned, and it will be much easier and less costly to deal with these issues up front than when the dispute arises later.

Read more about founders in my Founders Series Part I and Part II.

Founder Series Part I: How to Choose Your Founders

How can you sink your startup before you ever start?  Choose the wrong founders.  It sounds obvious, but in practice is remarkably challenging for many startups.  In this first post in my founder series based on a class I taught at MIT Sloan recently, I am going to focus on what you need in a team and what you should do without. Companies have taken a variety of methods in putting together founding teams.  Some ventures are started by a few old friends.  Others are placed together by serendipity.  Some go it alone.  Companies at one time of another may have found success with each of these.  But that does not mean each will work for yours.  Before you start, answer these three questions: (1) how many founders do you need? (2) What skills should a founder have? (3) Do the founders share a vision?'

How many founders should a startup have?

First, there is no one right answer to how many founders should be involved.  Facebook's Mark Zuckerberg went solo (at least officially), and seems to be doing o.k.  Others took a collaborative approach with four or five.  To figure out your answer keep it simple - use rules that know from a bar.  My favorite analogy for founders is the "martini rule": one is unusually not quite enough, but four of five is likely too many.

The more I work with startups, the more I see that two seems to be about the right number.  Three can work, but human nature says that you are inviting trouble.  Think about successful companies and inevitably you will associate them with two founding members.  Apple, Google, Microsoft, HP, and even newer startups like Foursquare, HubSpot, and Twitter all started with a pair of entrepreneurs.

I have had clients tell me that they "need" this person or that person on the founding team because of a long-standing friendship, or because they want a diversity of views, or even because they just happened to be involved in the early conversations and offered some suggestions.  A founding team is more than just payment for past actions (more on that in my next post) and friendships can change very quickly when money and business is involved.  Over time, the company will require contributions from many people to be successful, including advisors, but they don't all have to be founders.

What Skills Should a Founder Have?

The one thing that founders should have in common and that is that they are different.  Often, two people with similar skills make poor co-founders.  The best teams bring contrasting (but complementary) skills to the venture - a yin to your yang.

Keep in mind that you don't have it all.  A solid co-founder can be a very valuable partner in your new venture by helping you to stay focused, being a sounding board for ideas, and, simply put, as another set of hands to help manage the workload.

The key to a good co-founder is balance.  Each of you will bring different skills to the table that together will help propel the company.  If you like to code or tinker with products, another technie might not be the best fit.  Perhaps your co-founder should be a businessperson who can help sell your ideas (think Steve Jobs and Steve Wozniak).  Again, the complementary skills are key.

Vision

Finally, you need to share a vision with you co-founder.  I am not talking about on day one - everyone is excited and in alignment at the beginning.  But what about when things change?  Do you share a philosophy on dealing with the things you did not intend to deal with?

Many founding teams start to fall apart as things change.  They start to argue about what to do when the original plan is not working.  Or even worse, refuse to adjust when it is clear that you are headed in the wrong direction.

I saw a promising startup fall apart because they just could not agree on how to deal with an employee (who happened to be a friend of one of the founders).  This is when having history with your co-founder becomes important.  You will have a better idea about not only what skills they can bring, but also how those skills will help you evolve the company you will create together.

So what has your experience been?  What have you found works best when choosing your co-founders?

Read more about founders in my Founders Series Part Two and Part Three.