The subject of how to allocate shares in a startup and the general startup equity is something every startup founder who has no advanced formal education struggles to comprehend.
Most founders start out by owning their companies. As you grow as quickly as possible, you will need investment and to secure the capital you need, your investors will want to own part of your company.
The faster you grow, the greater your burn rate and the more capital will be required. You move from pre-seed to seed to Series A, bit with each cash injection, you are forced to give up another slice of your company. If you offer too little, your investment dries up, if you offer too much, you will soon find yourself without a slice in your own company.
The subject of share, capital, allocations, share types, and shareholding is complex. We shall try to simplify things for you.
Previously, having looked at how to determine the most ideal product-market fit strategy, we slightly shift attention to startup funding. Here is another guide, a part series of startup funding. In the guide, we shall look at all aspects touching on shares in a startup, by understanding what shares are, issues about shareholding, share classes, founding shares and steps to diving equity in a startup.
What are Shares?
Shares are units of ownership interest in a corporation or financial asset that is provided for an equal distribution in any profits in the form of dividends.
Shares represent ownership of a company. If someone buys shares in your company, they become one of its owners. It is the duty of shareholders to choose who runs a company. They are involved in making key decisions that affect the health of a business.
In most cases, shares are associated with the stock market. However, most businesses do not go near a stock market in their lifetime. In such a case, they are most likely to issue shares in their company in return for a large sum of investment.
This investment may come from friends and family, or from businesses that are looking for capital to fund high growth, through a formal equity funding finance. Formal equity financing may come from business angel investors, venture capital firms or stock markets.
Why are shares Issued?
Shares are issues due to different reasons including the following;
- New finance
- An exit for founding investors who want to realize their investment
- A mechanism for investors to trade shares
- Market valuation for the company
- An incentive for staff using shares or share option
- An acquisition currency in the form of shares
- A way to raise the business profile
How can someone become a shareholder?
If you buy or get shares in a corporation, you become a shareholder. There are different ways in which one can become a shareholder. These ways include the following
- Being listed as a shareholder in the company registration application
- The company issuing shares to you
- Buying shares from current shareholder
Share class rights
In any corporation, there are different classes of share rights. Each share is entitled to a vote in any circumstance. However, each share as an equal right to dividends. Each share is also entitled to participate in a distribution arising from a winding up of a company.
A Class Shares
Class A shares are common stocks. They are the common majority of shares that are issued. Common shares are ownership interest in a company and entitle their purchases to a portion of the profits earned. Investors in a common share are normally given at least a vote for each share they hold.
Class B Shares
Theoretically, a company can create any number of classes of shares of common stock. This is normally done in order to concentrate on voting power within a certain group of people. Class A carries more voting power than class B. Class A shares may offer 10 voting rights per stock held, while class B holds only one.
Apart from the issue of voting rights, different classes of common stocks almost carry the same equity interest in a company. This means shareholders of a company, irrespective of the classes, all have the same rights to share in company profits.
The difference between class A shares and Class B shares is usually in the number of voting rights assigned to the shareholder. Class A shares are common stocks, as are the vast majority of share issues. When a company has more than one class of stocks, it traditionally designates them as class A and Class B.
How many shares should a startup have?
Typically, a startup company has 10,000,000 authorized shares of common stock. However, as the company grows, it may increase the volume of shares as it issues them to employees and investors.
Shares, stocks, and equity are all the same thing. A share is one piece of ownership in a company. When you own shares, you become a shareholder. Owning shares in a company gives you the right to have part of the company’s earnings and everything it owns. The more shares you own, the bigger the par of profits you’re entitled to.
The first step to owning a company is to determine which type of corporation is the best match for your needs. There are two main choices to make;
Limited Liability Company
The easiest incorporation is an LLC. Unlike simpler entities such as sole proprietorship or general partnership, the LLC personally shields you, the founder, from business liability that could be incurred.
Many small businesses are set up this way. However, it is a bad structure for startups who may want to expand and take on outside investments. Venture capitalists will never invest in limited liability companies due to complications that may arise from pass-through taxation.
These ones may be cumbersome to set up and manage as compared to limited liability corporations. The C Corporation is the standard entity for most startups as it can smoothly take you from the idea conception stage to IPO. It is the entity of option for venture capitalists.
Unlike limited liability companies, C-Corps do not have to pay for corporation tax. However, they are more robust and scalable. If you apply for a startup accelerator program as an LLC, you will have to convert to a C-Corp before you can be accepted. If you don’t plan to raise capital outside your country and don’t aspire to go IPO, you can then operate as LLC.
Now that you have chosen the type of entity to incorporate your company, the next thing you need is to determine how many shares to authorize. It can be any number, but let us stick to the universal 10 million. Why 10 million though? – Because it is what everyone else does.
Additionally, 10 million is an easily divisible number. It is big enough such that when you give an employee say, about 10,000 stock options. Even psychologically it feels like a big number, even if it represents 0.1 % of the company.
10 million is also a convenient number especially if you are dealing with the price per share. If your company has a valuation of $10 million, each share would be worth $1. Anyway, just authorize 10 million shares because that is the norm for startups.
Number of Shares to Issue
It is important to understand the difference between authorized shares and issuing shares. Authorizing shares refer to the process of deciding how many slices of shares to cut in the share-pie. On the other hand, issuing shares happen when you perform the actual handing out of some of those shares.
Authorized but unissued shares are those pieces of pie still on the table. Once you have made a decision on how many shares to authorize, the next step is to determine how many shares to issue to the founding team.
Issuing shares to the founding team is the most complex and delicate issue you will have to handle. The general rule of the thumb is to allocate roughly half of the authorized shares to you and your co-founders. Doing so should give you enough space to make it through a different series of funding, including series A.
Let’s say we have issued 4 million shares to the founding team and set aside a million shares into a share option pool, purposely for future hires. In total, we shall have carved in 5 million shares.
To get to a round of series A funding, most startups would normally need to raise at least two prior rounds, which are pre-seed and seed funding. As a norm, you will need to give out 20-30% of your company at each round of funding.
If we start out with 5 million shares, and they get diluted 25% over three consecutive funding rounds, we shall still be within our 10 million authorized shares.
5,000,000 x 1.25 = 6.250,000
6,250,000 x 1.25 = 7,812, 500
7,812,500 x 1.25 = 9,765,625
How to allocate shares in a startup
At this point, you might be probably planning to authorize 10 million shares and issue a total of 4 to 5 million shares to you and your cofounders. However, you may decide to split it up between you. If that is the case, there is one very important concept you need to understand; vesting periods.
It is highly advisable that you and your co-founders agree on a vesting schedule for your founders’ stock. Here is a recommendation breakdown;
4-year vesting schedule: – With this schedule, your equity vests in 1/48 chunks, every month for 48 months.
1-yer cliff – With this arrangement, if you leave the company within one year, you do not take equity with you. Instead, the first ¼ of your equity vests on the 1-year anniversary.
Single-trigger acceleration – With this format, in the event of a company sale, all your unvested equity will vests immediately, even if the full four years have not elapsed.
Determining Founder Equity
To determine how you will distribute equity among co-founder will depend on the unique circumstances of your startup. There is no direct answer or a specific formula that can produce the perfect solution for this question.
However, as a starting point, you need to understand each founder’s value. Start by determining the role that each founder will play through the long-term development of your company. Ensure you have a good understanding of each founder’s expertise and experience when it comes to determining their roles.
Understand which founder is best suited to become a CEO and which ones are best suited for the technical aspects of your business to become CTO. As the company evolves, roles may change, so it is important, to begin with, some distinction in mind.
You should not be afraid to hold difficult conversations among yourselves. If roles, expectations, and responsibilities are not well defined, it may bring a lot of conflict in the future. Potential investors will always question your motives when they suspect anything fishy.
Share vesting is the process of awarding shares to employees or founders as part of the compensation package or pension plan to reward and retain individuals. The process of vesting shares happens over a certain period, usually 4-5 years.
Through vesting shares, a company is able to keep its employees loyal and committed to the company.
At the end of the vesting period, an individual is able to acquire rights over the shares or compensation plan, in accordance with the terms that were made prior to the start of the vesting period.
If a founder of a company is given shares for vesting, the terms of the agreement are normally found in the ‘shareholder’s agreement’. If an employee has been offered shares for vesting, the terms of such shares will be found under the ‘employment contract’.
Benefits of Offering Vesting
Vesting shares come with a number of benefits. These benefits will be spread both to the company and shareholders. Your company will not have to pay you as much cash compensation as equivalent. This is because shares are typically a representation of ownership of the company and not actual cash payments.
Getting an Attorney
Most startups hire a lawyer to handle all issues about incorporation. A good attorney should walk you through all the types of decisions we have covered above. They should be able to generate relevant documents and file your certificate of incorporation with the government.
As an employee, you will receive the benefit of either a potential windfall from vesting into an option or the direct benefit of vesting into shares. Additionally, vesting acts as an encouragement to employee retention. Very few employees will want to walk away from a company where they have vested shares.
Taxes on Vested Shares
The key issue to understand here is that vested shares are a form of compensation. The manner in which you get taxed will depend on the type of vested shares. If you’re vesting into an option, you will be taxed if you sell the stock. However, the amount you pay as the tax will depend on when you buy and sell it.
As we had mentioned earlier, we have three main forms of vesting schedules;
- A four-year vesting schedule
- A one-year cliff
- Single trigger acceleration
Most startups make use of vesting schedules. These schedules are intended to discourage people from leaving a startup and reduce the risk of diluting equity.
If a person leaves a company before the first year of a four year vesting schedule is completed, they will relinquish all equity they have vested. On the other hand, if a startup leaves before all the shared have been vested, they are immediately vested by default.
As it started from Silicon Valley companies, startup compensation in the form of vested shares is now a norm. Companies started offering stock options to their employees and now it is a trend. There are no laws that prevent employees from leaving a company or being poached by a rival company.
This, therefore, calls for the need to ensure startups high compensate and motivate their employees. Employees will always want to move to those companies that are offering them greener pastures and better packages.
If you vest into a stock award, you will be taxed in the compensation income the shares represent. For any type of vesting you have, you must report in the sale of any shares and pay all related taxes when you file your income tax returns.
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