After deciding your new business venture seems worth pursuing, you will have quite a few decisions to make regarding incorporating your new entity. You might decide to read online articles like this one and then take matters into your own hands without engaging expert help. Don’t do that.
Disclaimer: I am not a licensed attorney. This article is intended to generally educate and inform regarding your early capitalization decisions by leveraging the hundreds of examples I’ve witnessed and the best practices I’ve observed by skilled corporate attorneys. Get yourself one of those (skilled corporate attorney).
When I say “don’t do that”, I’m not talking about reading online articles to educate yourself and I’m also not suggesting you avoid using some online legal services. Rather, I strongly recommend you don’t avoid using an attorney just to save money. Doing so is likely to give you multiple instances of “by-the-book” debt that you’ll need to pay back later. If the online service you use has legal experts available to advise you, that’s possibly OK. But if you can possibly afford a skilled corporate attorney that regularly works with startups and early stage companies, do that.
Related Article and Online Risk Assessment: “Accumulated By-the-Book Debt Will Eventually Come Due”
Case Study Example
To demonstrate some of the issues and decisions you might face with your incorporation, let’s follow an example of an exciting new startup named Shockwave VR. They are barely out of the coffee shop with their idea written on three napkins and no lines of code yet written. They decide to incorporate as a Texas C-corporation with 1,000 authorized shares of Common stock at a par value of $0.0001 per share and a fair market value (FMV) of $20 per share. The two co-founders, Kelly and Gordon, decide to issue all of the shares into the company and agree to split the equity evenly via an outright, fully-vested grant. Below is their starting capitalization table (aka – “cap table”) that records the shareholder’s equity.
Do you happen to notice anything wrong with the approach Shockwave VR took for their incorporation? If you only see three or four things that are either wrong or at least suspicious, please keep reading because I’m about to describe seven issues with related recommendations. Please understand that my recommendations in each case are for the most common situations. Yours could totally call for a different approach and that’s why you’ll see me repeatedly recommend getting advice from licensed professionals.
Side Note: For this article, I don’t intend to cover the often-debated issue of initially incorporating as a C-corporation versus an LLC. Too many legal and accounting factors are involved and I’m far from an expert on most of them. Instead, talk to both your certified accountant and licensed corporate attorney to figure out what’s best for you.
(1) State of Incorporation
Kelly and Gordon live in Texas and intend to grow the company there. So why not incorporate in Texas? You’ll find lots of articles on this subject but, for most situations, corporate attorneys recommend incorporating in Delaware if you have plans to raise funding from institutional investors. By the way, this doesn’t mean you won’t also need to make some business-related filings in your home state and possibly even others. Check with your attorney.
Below are the most common reasons I’ve seen described for incorporating from the start in Delaware:
- Easy and well-known filing process
- All corporate and venture-focused attorneys learn Delaware law
- Predictable body of law and lots of case precedent to draw upon
- Dedicated court for corporate disputes – no juries
- Laws tend to be pro-management and protective of board members
- Allows for several classes of stock
- No reviews or approvals required by the state for fundraising actions
Related Article: Read Jose Ancer’s article titled “Should I Form My Austin Startup in Texas or Delaware”
RECOMMENDATION: Incorporate in Delaware
(2) Number of Shares
Kelly and Gordon decided on 1,000 shares because it seemed like a nice, round number. What they didn’t know is that 10 million is what many startup attorneys recommend and is definitely what I see most often.
I know, 10M shares seems like way more than is needed. After all, the equity granularity offered with 1,000 shares is 0.1% (1 / 1000 = 0.1%) and that seems pretty granular. There might be future needs for even more granularity but 10,000 or 100,000 shares would certainly accomplish that.
From what I can tell, the biggest benefit of incorporating with a huge 10M shares is a psychological and emotional one. With it, the quantity of shares offered to a new employee in their offer letter looks really attractive. 50 shares in Shockwave VR represents the same 5% equity as 500,000 shares in a company that instead incorporates with 10M shares. Which do you think hiring candidates would like to see in their offer letter. Again, it’s a psychological benefit.
I come across startups that decided to incorporate with a small number of shares solely due to Delaware’s annual franchise tax. Most of them only saw the tax calculation formula based on the number of authorized shares. What they missed was the option to instead pay taxes based on total gross assets (called the “Assumed Par Value Method”). Using this alternate method results in paying only the minimum-required franchise tax in almost all cases.
RECOMMENDATION: Incorporate with 10M authorized shares
(3) Authorized versus Issued Shares
In the case study example you might have noticed the reference to “authorizing” shares and “issuing” all of them into the company. These are actually two separate actions with different implications and they are enacted by some combination of Board authorizations and legal filings. The important thing to understand is that not all Authorized shares must be Issued into the company.
Holding some Authorized shares back for future Issuance into the company has advantages. There might be situations in which you need additional shares available versus those that have already been Issued into the company. Examples include increasing the size of the stock option pool (more to come on that soon) or issuing a Warrant to a venture fund or startup accelerator.
If you Issue all of the Authorized shares into the company right from the beginning like Kelly and Gordon did and later need more shares, you’ll need to make additional legal filings in Delaware to Authorize more shares and that will cost you both time (perhaps 2-3 weeks) and money (attorney fees, filing fees). Instead, hold 10-30% of the shares back by not Issuing all of the Authorized shares into the company.
RECOMMENDATION: Issue 8M of the total 10M into the company, which leaves 2M available for easy issuance in the future, when needed.
(4) Par Value and Fair Market Value (FMV)
I’ve written about this specific topic in another article, so will only recap the highlights here. The article is titled “Pricing Your Stock in the Early Days” and I highly recommend reading it to round out your education on initial capitalization and to understand the importance of escalating the FMV over time.
The Par Value is almost never used in practical purposes but is intended to represent the nominal value of the shares and, therefore, the value the company agrees to never go below when selling the same class of shares.
Many startups set the Par Value at a fraction of a penny, like $0.0001 or even as low as $0.00001. But the Par Value and the current Fair Market Value (FMV) of your Common shares are two different things. In the early days before companies have developed some real intellectual property and/or reached some amount of repeatable revenue, they often leave the two equal. How much can your business grow before you should start to escalate the FMV? It depends on who you ask and how conservative you want to be. (read the article mentioned above for more information)
RECOMMENDATION: Set a par value of $0.0001 and if you are still in the idea development stage or still developing a prototype product, set the FMV at the same $0.0001. Once you launch your product and convince some customers to pay you money for it, you’ll need to set the FMV higher.
(5) Equity Split
Kelly and Gordon decided to split the equity evenly. After all, they both came up with the original idea while having coffee together and they’ve both agreed to spend the same amount of time on the venture. They’re both equally experienced, albeit with Kelly on the technical side and Gordon on the business side. If it seems fair to them to split the equity evenly, what’s the problem?
The problem comes if/when there are important business matters that require a shareholder vote, according to the company’s Bylaws. If Kelly and Gordon don’t fundamentally agree, they’re stuck in a 50/50 tie vote. I’ve been personally involved as an outside advisor or unofficial arbitrator for “co-founder funk” situations more times than I can count.
I typically either find that one of the founders had the idea first and worked on it at least a little before other co-founders joined or that same founder will work on the venture at least a little more than the other co-founders until some round of funding closes and the others can join full-time. This gives an opportunity to adjust the equity split, even if just a little like is shown in the second version of Shockwave VR’s cap table below.
RECOMMENDATION: With a 2-person founding team, try to find some logic for adjusting the equity amounts to avoid an exact 50/50 split. If that’s impossible, consider adding a mutually-agreeable advisor with something like 0.5% or 1.0% equity. They can serve as a tie-breaker.
You might have noticed in the case study that Kelly and Gordon are getting their equity via a “fully-vested grant”. Yikes! What if Gordon quickly loses his passion for the venture and decides to start a new venture? He already owns his half of the equity in Shockwave VR but he isn’t planning to do anymore work for the company. This is referred to as “dead weight” on the cap table and, in this case, it’s HEAVY dead weight that future investors will hate to see.
The easy way to avoid this is to require that founders vest their equity over time rather than own it outright from the beginning. Even if it’s decided to allow for an early exercise via Restricted Stock Purchase (talk to your attorney), the equity can still carry a vesting schedule.
A vesting term you’ll want to educate yourself on is called a “cliff”. It’s partly used as a retention incentive and also protects against chunks of equity being owned by people that only worked for the company for a short period of time. With a cliff, no vesting occurs until the cliff date is reached but upon reaching it it’s as if the cliff never existed. As an example, with a 1-year cliff on a 4-year vesting schedule, upon reaching the 1-year mark, 25% of all equity immediately vests and then regular vesting (usually monthly) continues throughout the remaining 3 years or until the founder leaves the company.
If one of the founders has been working on the venture for 6 months or more before incorporation, you could give some sort of accommodation via a retroactive credit or a shorter cliff period.
RECOMMENDATION: Vest the founders’ equity over a 4-year period with monthly vesting after a 1-year “cliff” (at least 6 months for the cliff).
(7) Where’s the Stock Option Pool?
Surely Kelly and Gordon are planning for success and, with that, are going to need to hire some employees and maybe even some other executives. Maybe they are so stingy and greedy that they don’t plan to give those employees equity in Shockwave VR. But that’s only going to turn away a lot of good candidates. Authorizing and issuing new shares into the company with each employee addition is a big pain plus costs money each time. What Shockwave VR needs is a stock option pool.
Formally called the “Employee Incentive Plan” in most cases, a stock option pool (aka – “option pool”) is essentially a quantity of stock that is issued into the company but reserved for future use. In other words, it’s not initially assigned or granted to any particular individual but rather drawn from as those needs occur. You can use this stock for employees, advisors, board members, and even contractors/consultants that you compensate with equity.
Side Note: After you legally adopt a stock option plan to accompany your stock option pool, make sure to give a copy of the plan to anyone that is granted equity from the pool. The stock option grant document you will use to issue shares from the option pool almost certainly says you did this and not doing so could cause legal problems later if there’s a dispute.
The key decision to make with a stock option pool is how many shares to put into it. The method I use is to list out the expected additions of employees, advisors, board members and any others that I plan to grant equity to until an expected equity round of funding i thee future. Such a round of funding is a very logical time to “true up” the option pool with more equity. Next to each expected addition, list the anticipated amount of equity for the role. Add it all up and then include a buffer just in case. In other words, if it adds to 7.8%, consider creating a 10% option pool.
Related Resource: See suggested Stock Option Grant Guidelines for different company phases on the Resources page (in the Compensation-Related Resources category)
If when you incorporate you already have 3-4 founders with reasonably big chunks of equity each, you might only need a 10% option pool. But Kelly and Gordon might need to set aside 20-25%. They ultimately decide that 15% is the right amount and you’ll see that reflected in the third version of the Shockwave VR cap table below.
RECOMMENDATION: Create a stock option plan and stock option pool in conjunction with your initial incorporation. Use the method described above for determining the right amount of equity to allocate to the option pool.
This topic is informational versus something that requires a decision or something you might mess up. Until now we have been looking at equity percentages on what’s known as a “fully-diluted basis”. That is the ownership percentage assuming all issued shares are taken into consideration, including stock that is sitting in the option pool and still available for issuance to individuals.
Another way to look at the cap table is on what’s known as an “issued and outstanding basis”. That is the ownership percentage considering only the shares that have been granted to someone or some entity. As you can see in the final cap table example below, the difference is the removal of the stock option pool.
If Shockwave VR gets acquired for $1B, the equity ownership that matters is the Issued & Outstanding equity. That’s because during an acquisition, shares of stock that still sit in the option pool evaporate and aren’t taken into consideration. So with a $1B acquisition of Shockwave VR as it sits now, Kelly will get $501M (50.1% of $1B) and not a measly $426M (42.6% of $1B). You can think of your fully-diluted equity as your worst case ownership once the option pool is exhausted and assuming nothing else happens to dilute your equity (ie – future rounds of fundraising).
I hope this article demystified several things about initial capitalization and the ledger to track it called the “cap table”. Please follow my repeated advice to engage certified professionals to help you do all of this by-the-book right from the beginning. You’ll thank me later if you do.
Related Article and Online Risk Assessment: “Accumulated By-the-Book Debt Will Eventually Come Due”
My final recommendation if you plan to continue with your startup venture and aren’t already an expert in matters like capitalization or fundraising, read the book Venture Deals (click the image to the right). It will serve as your key reference guide for years to come.