Startup Law 101 Series – Mistakes Founders Make – Misunderstanding Capitalization.
The Issue – What It Means to Own “X% of the Company”
What does it mean that you own x% of a company?
Founders can get confused on this issue. Why? Because there are at least three possible points of reference by which to measure percentage ownership. It can be measured with reference to: (1) issued and outstanding shares only (the narrowest corporate measure); or (2) issued and outstanding shares as adjusted to reflect the maximum dilution possible from the exercise of all stock options and other contingent equity interests outstanding in the company (the “fully diluted” measure); or (3) authorized shares used as a working model of where a company’s board of directors believes the shareholders will be at some future date (the working model measure).
In its own way, each of these measures can legitimately be used by founders in discussing percentage ownership in a corporation. Problems can and do arise, though, when founders discuss this issue and take actions on it without thinking about which reference point they are using. Below I describe the problems this creates and note what to look for to minimize potential problems on this important issue.
What the Concept of “Authorized Shares” Means
When an entity is formed it is capitalized. This means that founders contribute cash or other assets to the entity and, in return, get an ownership interest in the entity. In a corporation, this ownership is evidenced by shares of stock. In an LLC, it is evidenced by a membership interest or perhaps by units evidencing such membership interest. Whether you get shares of stock or some form of ownership units, you will own a certain percent of the company as a whole.
In various contexts, this question – “what percent of the company do I own?” – can be significant. Sometimes a key person is promised x% of the company in exchange for some specific contribution. At the time of funding, founders are told that they will give up x% of their company to VCs in exchange for the dollar investment being made. When they are considering such issues, founders need to understand how this terminology is being used in order to avoid misunderstandings and potential problems.
We could explain how this works with either a corporation or an LLC. Let us use a corporation to illustrate the points.
When a corporation is formed, the charter document (articles or certificate of incorporation) specifies the number of “authorized shares.”
The concept of “authorized shares” is an important one in corporate law. A corporation is a legal person. Being an artificial person, it acts through agents. There are shareholders, who own the corporation. There are directors, who sit as a board and manage it at the highest level. And there are officers, who conduct its day-to-day operations. Shareholders control the corporation by controlling the board, which in turn makes the most important decisions for the corporation. Having been put in place by the shareholders, the board is responsible for making all key decisions that are out of the ordinary course of the day-to-day business operations of the company. One of these decisions is whether to issue stock to various persons and on what terms and conditions to do so.
The shareholders control the board.
The board determines what stock to issue and to whom and on what terms.
But the board must always act in the best interests of the corporation and its shareholders. Those who sit as directors on such a board have what the law calls a “fiduciary duty” to exercise the highest good faith and diligence to promote the interests of those shareholders.
To protect the shareholders, as the ultimate owners of the corporation, the corporate law sets an outer bound on what the board can do in issuing stock: the board can always vote to issue stock from the pool of shares authorized by the shareholders (or, initially, by the incorporator) for this purpose. It cannot exceed that bound. This rule protects the shareholders of a corporation from dilution of their ownership interest beyond the limits they have authorized.
So let’s recap again.
The shareholders control the board.
The board determines what stock to issue and to whom and on what terms.
In issuing shares, the board is ultimately limited in what it can issue by the number of shares previously authorized by the shareholders for this purpose — that is, the board’s authority to issue shares is ultimately capped by the number of authorized shares in the corporation.
This is important. The concept of “authorized” shares plays a vital role in corporate life by giving the shareholders an ultimate say on ownership issues in the corporation. But (and this is a big but), except when considered conceptually as the basis of a working model used for planning purposes only, the authorized-share concept has nothing whatever to do with what percentage of ownership interest any shareholder has at any given time.
Issued and Outstanding Shares as the Strict Corporate Measure
It is time for our first quiz.
You form a corporation and, as incorporator, designate 10 million as the number of authorized shares, all common stock.
You appoint yourself as the sole director and, acting as such, authorize 5 million shares to be issued to you as the sole shareholder. You pay for the shares and cause the corporation to issue them to you.
So, 10 million shares authorized and 5 million issued to you. What percent of the company do you own?
That’s right, you own 100%.
It is not, “I own 5 million of the 10 million authorized” and therefore 50% of the company. Remember, authorized shares have nothing to do with actual ownership at any given time in the corporation’s history. Only the issued shares count toward this purpose.
So, you own 5 million shares out of a total issued of 5 million and hence 100% of the company.
Let us extend the example. Say you have a co-founder who received 1 million shares at the same time as you got your 5 million.
What percent of the company do you own?
Now there are 6 million shares issued and outstanding. You own 5 million out of that total. Therefore, you own 5/6ths of the company, or approximately 83.3%. Your co-founder, in turn, owns 1 million out of the 6-million total, or 1/6th, or approximately 16.7%.
Again, none of this is calculated with reference to the 10 million shares authorized for this company. It is technically wrong, as a matter of corporate law, to say that you own 50% of the company in this example because you own 5 million out of the 10 million shares authorized, and it is equally wrong to say that your co-founder owns 10% in owning 1 million out of the 10 million authorized. Yet people will sometimes refer to the authorized shares as the basis for saying how much they or others own in a company and, when rightly considered, this has a certain logic to it. Let us consider, then, how this comes up.
A Potential Ambiguity from Using a Working Model as a Point of Reference
Let us now extend the example further and assume that you promise a key person who will be joining up with you and your co-founder that he will get 2% of your company if he does this or that.
In technical terms under corporate law, what is it that you have promised when you make such a statement? Well, there are 6 million shares issued, 5 to you and 1 to your co-founder. If you take 2% of the 10 million authorized shares, your key person would get 200,000 shares. But 200,000 in relation to the 6 million shares issued (plus 200,000 to be issued) is not a 2% ownership interest but rather about 3.2% (200,000/6,200,000). In technical terms, the 2% interest would be just over 120,000 shares (120,000/6,120,000 equals just under 2%).
While this is the technically accurate outcome, it is true that most parties, when discussing what “2% of the company” would mean in the above example, would likely think of the number 200,000. Why? Because they know that a corporation, or at least one functioning as an entity for a startup business, does not sit stagnant. It operates according to a working model.
In authorizing 10 million shares, you likely are working on the assumption that the 10 million shares will eventually be issued. You might even be thinking something like this: OK, 6 million shares to the founders, 2 million for an equity pool to be issued to key people, and 2 million for future investors. Hence, based on your working model, the correct way of interpreting “2% of the company” would be 200,000 shares, even though this would be wrong under strict rules of corporate law.
In a sense, both views are right. One measures the 2% with reference to existing shareholdings and the other with reference to anticipated shareholdings in the company.
It is precisely for this reason that founders get into trouble by making promises like “I will give you 2% of the company,” at least if they don’t clarify what they mean. Technically, under corporate law, this would mean just over 120,000 shares in our example. But if the recipient says he understood it as being measured with reference to the company’s working model, you have a problem and maybe even a lawsuit on your hands.
Issued and Outstanding Shares as Measured on a Fully-Diluted Basis
Let us shift to a different example to explain this further.
You have 10 million shares authorized, 4 million shares issued to founders, 2 million to investors who hold preferred stock convertible into common at a 1 to 1 ratio, and a total of 1 million stock options issued, none of which have yet been exercised. You are one of the founders and you own 1 million shares.
What percent of the company do you own?
Well, you clearly have 6 million shares issued and outstanding (4 to founders and 2 to investors). Does this mean you own 1 million out of the 6 total, or 1/6th, or just a shade under 16.7%. The answer is: yes and no.
Yes, in technical corporate terms. If your company were acquired in just that instant, and nothing in the acquisition made the options exercisable and none of the options were or could be exercised as of the closing date of the acquisition, you would share in exactly 1/6th of the total proceeds. If the company were acquired for $6 million cash, net of expenses, you would get exactly $1 million for your shares.
But no, not really. Because, while the above presents an accurate picture of what might happen in a particular instant of corporate time, the options in reality will likely become exercisable over the course of time and will or at least may be exercised in whole or in part. Indeed, the very point of issuing options is to provide incentives for key people. If they were not exercisable, that would defeat the point.
Therefore, you need to figure options (and all other contingent equity rights, such as warrants) into the equation to determine what percent of a company you really own. The technical term for taking all these into account is to say that you own “x% of a company on a fully-diluted basis.”
If we look at our example using the “fully-diluted basis” measure, then, you would own 1 million out of a total of 7 million shares either issued and outstanding or issued contingently and capable of being converted into shares in the future. Thus, you would own 1/7th of the company, or just a shade under 14.3%.
Does this mean that you might not actually get a higher percentage should an acquisition occur before all those options and other contingent interests were all exercised? Almost undeniably, you would get some higher percentage interest in most real-world situations.
Why? Because options typically require vesting and not all holders of options will vest in full. Thus, some options will simply be lost to their holders and would hence be subtracted from future computations of the “fully-diluted” capitalization of the company. Still other options will not have acceleration provisions attached to them and will not be vested (and hence not exercisable) at the time of any acquisition.
While the exact outcome is in flux, this arises from the nature of the equity interests in a dynamic startup and not from the measure itself. The fully-diluted measure is in fact the most accurate way of assessing the percent of a company that one has at any given time.
Let us again recap regarding the available measures for measuring percentage ownership in a company. In our first example above, we identified two reference points that might create ambiguity in how a shareholder might understand his percentage of company ownership: his holdings might be measured with reference to issued and outstanding shares only or it might be measured with reference to the company’s working model. To this we must now add yet a third one (the fully-diluted measure): shares can be measured with reference to the total of all shares, option rights, and other contingent rights outstanding in a company by assuming that all such contingent rights have been converted into shares.
How Capitalization Is Measured in VC Funding Deals and the Potential for Confusion by Founders
Now let go one step further to see how VCs measure capitalization at the time they make their investments.
VCs will typically take preferred stock but the nature of the stock they receive is not relevant to our illustration if we assume that their preferred stock will ultimately be convertible 1 for 1 into common stock (which we will assume here).
Let us go back to our example with 10 million authorized shares. You are a founding team holding 4 million shares total, which you issued to yourselves at trivial pricing at the time of company formation. Now you negotiate with the VCs a $6 million “pre-money” valuation for your company. They are prepared to invest $4 million in a Series A round. When added to the pre-money valuation, this gives the company a value “post-money” of $10 million. The VCs will pay $1 per share for their stock based on these valuations. They get 4 million shares for their $4 million.
In this example, the founders have 4 million shares, the VCs have 4 million shares, and the remaining 2 million shares out of the authorized total are designated as being set aside for an equity pool of shares to be issued to key people as incentives.
Now, it is the near-universal rule among startups to treat this scenario as one in which the founders “get 40% of the company,” the VCs “get 40% of the company,” and the remaining 20% is reserved for equity incentives.
This type of assessment is accurate if we assume that such percentage computations are calculated with reference to the working model negotiated between the founders and the VCs for this investment.
And there is, of course, nothing wrong with such an assessment. It is exactly what the parties have in mind when they make such a deal. Indeed, every such deal is accompanied by a sophisticated “cap table” that spells out the company capitalization in intricate detail, factoring everything possible that might contribute to the ultimate dilution of the total shares.
Yet great confusion typically results from this method of figuring and discussing capitalization.
Why? Because, in reality, under corporate law, the founding team that just did this deal has given up 50% of its company, not the 40% discussed with the VCs under the working model.
When control issues are discussed, you have in this case a classic case of shared control because each group holds an identical interest, just as in any 50-50 situation.
If, by some miracle, the company were to be acquired the day after the Series A closing in this example, the VCs would get 50% of the net proceeds of the sale, not 40%.
If part of the negotiated terms included giving the VCs the right to designate an outside CEO who would get a large grant of stock as part of his compensation, the control would shift immediately and decisively to the VC side. They would not need a full 10% shift, as might be implied from the idea that they hold a 40% interest. They would need only the slightest shift to hold just a bit more than 50% and thereby gain control.
I do not raise these issues to imply perfidy on the part of VCs. The deals so structured are legitimate ones. The parties know what they are doing and specifically negotiate them in just such a fashion, each to attempt to achieve its goals. And those goals are by no means seen as adversarial at their core. All parties see the structure as one by which they can work together to their mutual benefit. The investors have as much right to protect their investment as founders do to protect their position. In reality, each side works cooperatively with the other while taking formal steps to protect itself from potential abuse. This makes sense and is a healthy outcome for all concerned. Issues such as control are often negotiated in great detail and there are often agreed-upon terms specifying who will get what board seats and the like.
What I do mean to say here, though, is that founders need to understand the full implications of what they are doing when they do such deals. In the example just cited, they are not giving up 40% of their company but 50%. Yes, if it all plays out and the equity pool is ultimately exhausted, it will turn out to be 40%, as each of the 50-50 players will be progressively diluted to 40% as the pool shares are issued and converted into stock.
As a founder, by all means, do such deals when they meet your interests and those of your company. Just understand their implications. Should you encounter an unscrupulous VC firm under such an arrangement, you may find yourself out in the cold long before the equity pool is exhausted and your founding team’s theoretical interest diluted to 40%. Once control is lost, moreover, any shares you own that are subject to vesting would likely be forfeited if a coup occurred and your service relationship with the company arbitrarily terminated.
Do the deals, then, but understand the risks. A good VC firm will add value far beyond its money investment. A bad one can cause problems far beyond the dollar impact of its investment. When you make assumptions about who owns what percent of a company, and who can do what as a result of that ownership, you need to know which shares count and which are only part of a working model that do not count toward ownership under corporate law as measured on the day the VC round closes.
We have reviewed various scenarios of what it means to “own x% of the company.” As you have seen, the phrase can mean different things to different people, depending on whether it is being measured by actual shares issued, by such shares when “fully diluted,” or by a working model that makes assumptions about what shares will be issued in the future. All are legitimate modes of measurement, depending on the situation. Just make sure you understand which is being used when you assess your own interest and the interests being granted by your company to key people and to investors. If you fail to do so, you may get into trouble.
Of course, don’t forget to check with a good business lawyer on all such issues. The decisions will always be yours but you should make them with open eyes. A good attorney will help immeasurably on such issues. Don’t neglect this resource.