Concept of “Authorized Shares”
A business is capitalized by capital contributions from shareholders and retained earnings from operations. Shareholders receive shares of the corporation (representing an ownership interest in the corporation) in return for their contributions. To distribute shares, the corporation must “authorize” those shares. This is done in the articles of incorporation. The articles will simply state how many shares are authorized for distribution by the board and the classes of authorized shares. Subsequently, the board of directors will distribute those shares as part of a subscription agreement (agreement to invest funds in exchange for stock shares) or pursuant to a stock compensation plan to employees of the corporation.
The requirement that the articles of organization authorizes the classes and number of shares is a state law designed to protect shareholders. Shareholders must vote to change the articles of incorporation. It cannot be done unilaterally by the board. While the board may vote to issue any of the authorized shares, it cannot go further than that. This protects shareholders against dilution of their ownership interest by board action beyond issuance of the authorized shares.
How Many Shares to Authorize
There is no required or set number of shares to authorize. Corporations will use the authorized shares in future rounds of equity offerings and for employee compensation. It is important to offer enough shares to fulfill these objectives.
Common shares of stock are the basic unit of ownership for every corporation. Every corporation must have a class of common stock. A common share represents one unit of all of the authorized units (authorized shares) of ownership of the corporation. It entitles the holder to one vote in any election in which shareholders participate. Further, the default rules state that the common share holder has equal rights as to all other common shareholders. Founders generally receive common stock at the time of founding the corporation.
Preferred shares constitute an alternative class of stock authorized in the articles. As the name implies, preferred shares give certain rights to holders that are preferential in comparison to the rights of common shareholders. Companies generally use the preferential provisions of preferred shares to attract equity investors.
Investors generally received preferred shares with any number of preferred rights. For example, preferred shareholders may have priority with regard to dividends (defined rights to receive dividends or cumulative rights over time). Further, preferred shares may receive a liquidation preference if the business is sold. In the same vein, the preferred share may protect against dilution in the event of authorization of additional common shares. This is normally done through a conversion ratio that allows preferred shares to be converted to common shares. The preferred shareholder may have superior voting rights (such as multiple votes per share, the right to vote for certain director seats or for certain corporate actions).
- Note: The common characteristics of preferred shares issued to equity investors are covered in greater detail in subsequent lectures.
Options to Purchase Shares
Often companies, instead of issuing stock to an employee, will issue options to that employee. Options allow the employee to purchase stock at some point in the future at a pre-determined exercise price. The real benefit of using options to purchase stock is for tax benefits. An option to purchase stock at the current value of the stock is not taxable. The recipient has not received a monetary gain from the grant. (Note: If the option allows the recipient to purchase stock at a price less than the current value, then the difference between the strike price and the current value is immediately taxable to the recipient of the option).
Preferred Convertible Stock
Voluntary Conversion Provisions
Equity investors often demand preferred shares from the corporation. The most common characteristic of preferred shares issued to equity investors is the ability to convert the preferred shares into common shares. Investors often negotiate for a liquidation preference upon the sale of the company. This means that the investor receives some multiple of their money invested before the common shareholders receive any money. The investor’s return on investment may be capped after receiving her liquidation preference, with the rest of the proceeds going to the common shareholders. At some point, a company may be so valuable that the common shareholder will receive a higher percentage of the proceeds of sale that a holder of a preferred share. In such cases, the preferred shareholder will elect to convert her shares into common shares.
Mandatory Conversion Provisions
Preferred shares may be subject to mandatory conversion to common shares at some point in the future. Startup ventures intend some form of exit for its owners (all shareholders) at some point in the future. This is normally achieved through acquisition by another company (i.e., a merger) or through an initial public offering (IPO). In either event, having common at preferred shares at the time of merger or IPO would make the process very difficult. The purchasing shareholders would feel uneasy purchasing common shares when there is a class of preferred shares in existence. As such, to facilitate the merger or IPO process, the preferred shareholder may be forced to convert her shares to common shares at a predetermined time or upon the occurrence of certain events within the startup. In the event of mandatory conversion, the preferred shares will convert at a ratio that preserves the value of the preferred shares. That is, if there is a liquidation preference, that will be calculated into the conversion price for the preferred shares.
Preferred Share Liquidation Preference
A liquidation preference for preferred shares allows the investor priority in recuperating her investment if the company is sold or undergoes some other exit event. A liquidation preference is a security measure to mitigate the investor’s risk of financial loss as compared to other shareholders (the entrepreneur). Basically, the investor gets paid ahead of other shareholders. The liquidation preference often goes beyond simply assuring a return of the investor’s funds – it may return some multiple of the initial investment. This means the investor will get some multiple of their invested capital (2x, 3x, 5x, etc.) if the company goes through an exit event. This is the primary method by which investors are compensated. While generally understood to mitigate risk for the investor and shift that risk onto the entrepreneur, a liquidation preference protects against opportunism by the entrepreneur in seeking an exit event that does not benefit the investor.
Liquidation Preference and Conversion Rights
Liquidation preferences are closely connected with conversion rights. Generally, an investor will not convert preferred shares to common shares when the value of the common shares is less than the liquidation preference amount. Conversely, if the value of the preferred shares when converted to common stock exceeds the liquidation preference, then there is an incentive to convert the shares. The liquidation preference protects the investor against early exits that fail to capture the anticipated value of the business venture by allowing the investor to be compensated (or receive a return on capital) before the entrepreneur receives any funds from the exit event.
Participation rights give the shareholder the right to participate, along with other shareholders (the entrepreneur), in receiving any distributions from the sale of the business or other exit events. The participating stockholder receives a percentage of the funds distributed that is equal to her percentage of equity ownership in the business. Participation rights generally arise in the context of a liquidation preference. If the investor reserves a liquidation preference, she may also demand the right to participate along with other shareholders in any distributions above the amount of the liquidation preference.
- Example: Tom invests $10 in Mike’s business with a 5x liquidation preference. He also gets equal participation rights with Mike. The business sells for $200. Tom will get $50. Mike and Tom will split the remaining $150 ($75 each).
The terms of the liquidation preference may allow the entrepreneur to “catch up” before the investor receives any amount above the liquidation preference.
- Example: If Mike had “catch-up rights” then Tom would receive $50, Mike would receive $50. Tom and Mike would then participate equally in the remaining $100 of proceeds ($50 each).
While participation rights are often combined with a liquidation preference, an unlimited participation right is generally seen as overly generous to the investor and is frequently capped. As such, the participation rights will generally have a cap at a negotiated amount.
- Example: In the first scenario above, if Tom’s participation rights were capped at $50, the distribution of proceeds would be 1) Tom would receive the first $50 as his liquidation preference, 2) Tom and Mike would participate equally up to $100 ($50 each), 3) Mike would receive the remaining $50 (as Tom reached his participation cap).
Participating Convertible Preferred Shares
The class of equity demanded by investors in most venture capital financings is preferred convertible participating shares (PCP). As discussed in prior lectures, this class of shares has conversion rights to common stock. The shares will have both voluntary and mandatory conversion provisions. It also grants a liquidation preference with participation rights after return of the liquidation preference. The participation rights may be capped at a certain amount; otherwise, voluntary conversion rights would be largely irrelevant, as the value of the common stock would never eclipse the value of the preferred stock. There will always be a mandatory conversion provision in the equity instrument. As discussed in the convertible stock lecture, mandatory conversion provides comfort to later purchasers of shares that there is only one class of stock to consider. Continuing with the subject of participation rights, the nature of the shares may allow other shareholders to catch up before participations rights begin. In this situation, the terms may allow for unlimited participation rights.
Issued and Outstanding Shares
As previously discussed, authorized shares are the number of shares (of any class) that are listed in the articles of incorporation. Issued shares are shares that are actually distributed to shareholders. Outstanding shares may have a little more broad of a definition. It may include all promises or obligations to issue shares, such as options and warrants. This bring up the concept of fully-diluted shares.
There are multiple options for calculating the total number of outstanding shares. The calculation may include just the issued shares, or it may include all promises or obligations to issue shares. This is known as a “Fully-diluted basis” for calculating outstanding shares. Fully-diluted calculation of outstanding shares includes: common shares, preferred shares, warrants, options, options pool, and any convertible securities (such as convertible debt). Remember, warrants, options, and other convertible instruments will have a conversion ratio that may convert the instrument into any number of common shares. You will use the conversion to common shares ratio to calculate the total, full-diluted number of common shares. The effect of these different methods greatly effects the ownership percentage calculation.
Capitalization – An How to Investors Calculate It
Capitalization refers to the value of the outstanding shares. As such, the calculation of outstanding shares is relevant to determining the percentage of ownership. As mentioned a separate lecture, the number of outstanding shares may be calculated as:
- issued shares only;
- issued and outstanding shares that include all options, warrants, and convertible instruments that could convert into common shares (the “fully diluted” measure); or
- authorized shares taking into consideration the possible options, warrants, and conversions; but, also estimating a certain number of forfeiture of shares and buy-backs by the company.
Ownership percentage is calculated based upon common shares. Each measure will affect the ownership percentage of a holder of common shares. The calculation gets a bit more complicated when calculating in whether options to purchase for shares have vested or no. Non-vested shares are still subject to forfeiture. Calculating the fully-diluted shares thus makes assumptions about the vesting (and forfeiture) of shares.
Any investment calculation will be represented in a capitalization table “Cap Table” that lays out the outstanding shares and those to be awarded in the transaction. The Cap Table will indicate the category of equity ownerships (common shares, preferred shares, warrants, options, convertible debt). The Cap Table will also account for the pool of shares typically set aside for use as compensation for managers of the firm. Option pools are discussed in a separate lecture. Below is an example of a Cap Table.
When seeking equity investment, the investor will generally require that a pool of stock (generally common stock) be set aside from the authorized shares to compensate new and current employees. More specifically, the shares are used as a method to attract new talent that are are only interested in joining the startup venture as an equity owner. The shares (or sometimes options to buy the shares) will vest over a period of time. These shares will be forfeited if the employee leaves the startup prior to vesting. Further, these shares will be part of a buy-sell agreement where the startup either has the option or is obligated to repurchase the vested shares at the time that a shareholder leaves the firm.
Options Pools and the Effect on Capitalization
As explained in previous lectures, an investor will determine the pre-money valuation of the firm. That is, she will determine the value of the startup venture without the investment funds. Let’s say for example that the pre-money valuation is $2,000. If she invests $200, then after the investment the total value of the startup is $3,000 ($2,000 + $1,000). As such, she will require 1/3 ownership of the company for the investment of her $1,000. If there are $3,000 authorized shares, she will receive 1000 for her $1,000. This will give her the 1/3 ownership. If, however, there is need to reserve an option pool, this could affect her ownership interest.
There are two ways to approach the option pool. The option pool can come from all shareholders (entrepreneurs and investors) equally, or it can come solely from the entrepreneur’s shares. In the above example, let’s say that there is intention to reserve an option pool of 300 shares (10% of ownership). If the shares come from all shareholders, then this will reduce the investor’s percentage of ownership by 10%. She will own 900 of the outstanding 3,000 shares. This reduces her ownership percentage from 33.3% to 30%. The entrepreneur’s ownership percentage is also reduced by 10%. If the total option pool comes from the entrepreneur’s ownership, the investor will receive 1,000 shares, the option pool will reserve 300 shares, and the entrepreneur will receive 1,700 shares. In this situation, only the entrepreneur is affected by the option pool. This is typically the arrangement demanded by the investor.
Startup Founders and Equity Funding
At the beginning of the life of any business venture, the business has no resources. It is, in fact, a legal shell that must be filled. Founders are generally the sole source of assets in a startup venture. That is, the founders undertake the task of assembling resources necessary to carry out the business’ value proposition. These assets are transferred to the ownership and control of the business entity. In return for assets invested, the founders receive shares of ownership of the business entity.
Thus far, I have used the word assets to include all value that is transferred to the business. These assets generally consists of financial capital. In addition to funds, however, founders may contribute various other types of value to the venture. For example, founders may contribute:
- Ideation (or contribution of the original business idea, product or service model);
- Work Product or Effort (i.e., equity shares as salary or other compensation);
- Physical Assets (Equipment, Office Space, Inventory, Raw Materials, etc);
- Intellectual Property (Rights to technology, brand name);
- Reputation and Connections (personal relationship, such as with vendors, suppliers, lenders, capital investors, etc.).
Each of these founder contributions has distinct value to the business that is helpful or necessary for carrying out the business value proposition. The contribution of these items may give rise to an allocation of ownership interest (e.g., shares of stock) that represents its value to the corporation. In addition, this transfer to the corporation necessary entails a translation of the specific value into a monetary figure (i.e., it is given a dollar value). The financial value of such contributions is often difficult to determine. Nonetheless, the team will have to decide what number of total shares to allocate to the contributor for each contributed resource. Each share has a prescribed monetary value (either based upon the par value of the shares assigned in the articles of incorporation or based upon some business valuation method).
The allocation of shares for the value contributed may lead to unequal ownership and control among the founders. Naturally, this may lead to dissension within the team.
Equity Split Between Co-Founders
As discussed in previous lecture, the founders of the business provide the initial infusion of assets to fund the business. Allocating the shares of ownership interest in the business between founders can be difficult. Allocation of ownership is based on any number of factors, but it primarily concerns the value of assets contributed to the business.
As such we propose this systematic method for allocating ownership interest in the new venture to founders.
Step 1: Take the total number of founders and allocate 100 shares to each founder.
- Example: A = 100 / B = 100 / C = 100 / D = 100
- Note: This initial step assumes that everyone who is considered a founder is equally interested in being owners of the business. This also assumes that no value has yet been contributed to the business venture. The next step will involve the addition of a percentage of shares based upon contributions of value.
- Step 2: Identify major elements of value that will or could be contributed to the business:
- Prior Work Contributed
- Note: This includes the effort put into the business concept, product, service model, etc.
- Example: It may include: ideation or coming up with the idea; developing a prototype; researching the concept for feasibility; or any other initial effort prior to the formation of the business entity.
- Future Pledge of Work to Contribute
- Note: This includes the role that the individual will assume in the venture, the requirements of that role, and the value of the role to the operations or success of the business.
- Example: Defined roles such as CEO, CFO, CMO, Sales and Business Development, etc. Consider full-time vs part-time status as a consideration for the amount of effort the individual will be required or able to invest in the business. Lastly, consider the value of that role to the business, either operationally or strategically. For example, an individuals expertise or know-how may be absolutely necessary to the business. Even if one founder may work harder or dedicate more time in her business role, another founder may be indispensable to the business achieving its strategic objectives. As such, you must account for this in the allocation of ownership interest.
- Physical Assets;
- Note: This includes any form of tangible asset contributed to the business.
- Example: Think of equipment, real estate, inventory, raw materials, etc.
- Intangible Assets;
- Note: Intangible assets include intellectual property and reputation assets.
- Example: Intellectual property means any assets subject to patents, trademarks, copyright, or trade Secrets. It also includes property rights secured in domain names and state-registered, entity names. Reputation assets include any benefits derived from personal brand or resource connections (such as suppliers, vendors, lenders, equity investors, etc.).
Step 3: Calculate a percentage increase for each element of value contributed to the business venture:
- Example: (These are not the real percentages. This section provides a method. You should adjust the percentage to meet your business needs.)
- Prior Work Contributed:
- Idea: Add 2-25% (in this case 10 shares) to the originator or split between originators.
- Note: 10% is just an example. It may surprise people that coming up with the idea is not that valuable when it comes to awarding initial equity. The idea is simply not worth much without additional effort.
- Early Development: Add between 25-100% to each member depending on the amount of effort devoted.
- Example: Developing a prototype may be more valuable than carrying out an initial consumer test for viability.
- Future Work Contributed: Add between 25 – 200%
- Note: The individuals working in the firm may receive a salary, bonus or other compensation for their efforts. By virtue of their dedication to firm, they will demand an increased ownership percentage to assure that they benefit from the eventual success of the firm.
- Example: The CEO and individual in charge of sales may receive between 100% – 200%, while the person in charge of internal accounting and finance may only receive 25%. This comes down to the level of demand for the position or role (both in skill and effort. In such a case, those allocated to accounting, finance, compliance, etc., may draw a salary that equals or exceeds the other positions. This comes in exchange for the lower equity reward.).
- Physical Assets Contributed: Add 10 – 200%
- Note: At an early stage, assets contributed can be very valuable. You have to look at the value of assets (or $ of funds contributed) in comparison to a reasonable valuation for the business. A pre-revenue business is generally not worth much. This may change if the business has some form of competitive advantage (such as a strong patent). Soon into operations, however, the value of early contributed assets quickly diminishes as the business grows. That is, the value of contributed assets or funds compared to the growing value of the business diminishes. Hence the expression, early equity investment is expensive.
- Intangible Assets Contributed: Add 5 – 300%
- Note: The value of contributed intellectual property varies dramatically with the type and nature of the property.
- Example: Contributing a strong patent that effectively eliminates direct competition in the space is very valuable. A weaker paten or trademark to a brand name that is unsubstantiated has very little value.
- Idea: Add 2-25% (in this case 10 shares) to the originator or split between originators.
- Note: Never subtract value. Each potential founder is given a starting point of equal ownership in a business that currently has no value. We use the metric 100 because it is a round number that makes calculation of percentage increase very easy. Remember, you only include individuals who are founders and will be involved in the contribution of value to the business.
- Prior Work Contributed:
To illustrate the above calculations, let’s use the case of Adam (A), Bill (B), Carla (C), and Dana (D). The initial division of equity is equal between the founders. The company is a technology product that fills a void in the automated, B2B, customer marketing space. Adam came up with the idea and brought it to Clara (+5%). Clara and Adam worked together on functionality and design (+25% each). They approached Bill to code the initial program. Bill is very talented and they could not afford to pay him, so they agreed to award him in equity (+25%). They quickly needed to raise money and looked to Dana. With no patent awarded, no revenue, and no clients, Dana made a high-risk, friends & family loan of $50,000 (+200%). Dana has a strong reputation as a smart entrepreneur and investor. He brings a wealth of contacts in the industry and his strong personal finances allows for opening a line of credit to the business +200%). Adam and Clara have quit their jobs and will work on the business full time as CEO and Head of Marketing & Sales, respectively (+150 each). Bill will continue to work part-time for the business on maintaining and de-bugging the code (+10%). Adam and Clara jointly file for patent protection and transfer all intellectual property rights to the business.
Adam = 100 +5 + 25 + 150 + 100 = 380 shares
Bill = 100 + 25 +10 = 135 shares
Clara = 100 + 25 + 150 + 100 = 375 shares
Dana = 100 + 200 + 200 = 500 shares
The above results may surprise you. Adam and Clara are roughly 27% owners. It should be expected that their ownership is roughly similar, but 27% seems low. Dana, on the other hand, owns 36% of the business and she is doing very little. Bill provided all of the technical knowledge (which would have been prohibitively expensive), has about 10% of the business. The fact of the matter is Dana held all of the early risk. Further, it is her reputation that makes the business possible. Early investors often come out even better than Dana in this scenario. Until Adam and Clara quit their jobs, they really had nothing to cement them together as majority owners. This should illustrate that until a business has revenue or significant competitive advantage, it is not as valuable as it may seem. Bill’s situation should illustrate the alternative to being able to pay highly competent individuals early in the life of the business.
The allocation of ownership interest in the business is closely tied to the level of control, authority, or influence of the shareholders. As such, it is an emotional hotbed. This effort can be a real milestone for the business. Make certain that this allocation does not cause issues that will cause long-term dissension that could thwart achievement of the business’ goals.
Early Creators of IP as Founders or Equity Holders
Often, intellectual property is the most valuable assets a company has. For an extreme example, think of the music industry. At Michael Jackson’s death his portfolio of music masters was worth more than $1 Billion. In many cases, early founders will have worked together to create intellectual property that is the heart of the business. Since each co-creator has rights in the intellectual property, it is important that everyone involved transfer their rights in the intellectual property to the business. In return, these IP creators will want a share of ownership interest in the business. It is rare that a creator of IP will accept or a new venture will be able to purchase IP from its creator. Instead, these individuals often become early equity owners. This is true even if those individuals do not continue on with the business. Often the individuals working together on an early venture do not stay together through the difficult growth and development of the business. Look at the early Microsoft team. Only two of the large founding group remained in the company as something other than silent shareholders at the time it went public.
Difficulties with Issuing Equity for IP
The primary concerns when exchanging equity ownership for intellectual property rights are valuation of the intellectual property and other laws governing the transfer.
Valuing intellectual property is difficult. There are any number of methods that one can employ in arriving at a valuation. Unfortunately, there is no single readily accepted method. As such, exchanging equity for ownership rights can lead to unintended tax consequences for the IP holder. That is, the IRS may hold that the exchange of equity is taxable compensation to the recipient. There must be an exemption under section 721 for partnership-taxed entities and section 351 for corporate-taxed entities. See our business taxation material for more information on tax repercussions of equity for property.
- Note: This is a concern for any transfer of property to a business entity in exchange for an ownership interest.
The ability to transfer intellectual property is governed by a combination of state and federal law. Specifically, it involves state contract law and a combination of federal and state intellectual property laws. A contract is only enforceable to the extent of its terms. It can be tricky to adequately identify exactly what is included when transferring intellectual property. Federal patent laws have strict requirements on who can file a patent. Until a patent is awarded, transferring rights in the patent is difficult. Also, enforcing those rights may be challenged.
Founder’s stock is simply the common stock of the corporation issued to founders at the time of formation. At the time of formation, founders issue the stock at a very low valuation (e.g., .01 or .001). This is permissible, as the company is simply a shell at the time of formation. It technically has not value until it is funded. Once the company is funded and as the company grows the stock will become more valuable. Founders who receive the early stock face little or no taxation due to the low value. If the founders receive the stock after it has appreciated, then it would be a higher tax liability. Because the stock is awarded very early at a low valuation, the holders are not taxed on the appreciation in stock until it is sold.
Often times, the founders will not receive all (or any) of their shares of equity at the initial issuance. Rather, the award of stock will vest over an extended period of time, known as “restricted stock”. This is the case when the founder receives her ownership interest in exchange for continued work for the corporation. In this fashion, the corporation is protected from having to repurchase all of the shares in the event the founder/office leaves the corporation. As long as the stock is subject to a substantial risk of forfeiture, it is not taxed at that time. Founders can, however, recognize the value of the stock as compensation before it vests. This allows them to pay a much lower tax rate if the stock rises in value before it vests.
Options for Early Employees (Nearly Founders)
Once the startup begins to increase in value, most startups cease issuing common stock (Founder’s shares) to new employees. Awarding shares to employees constitutes compensation, which is subject to income tax. To avoid taxation and achieve tax deferment, the startup issues options to purchase the common stock at the current price. Since the stock option has no value at this point, it is not taxable. The employee will defer recognition of any appreciation of stock until the option is exercised. At that point, the value of the stock will be subject to taxation at that income tax rate. Options may vest immediately or over time. The founder has the option of recognizing the award of the stock option as taxable income at the time of issuance. This means that the value of the underlying stock will be treated as income to the employee and the value of the stock at that time will be immediately taxed at ordinary income rates. The benefit to this option is that, when the option is later exercised (i.e., receives common shares for the option), the appreciation in the value of the stock will be treated as capital gains. Capital gains are generally taxed at a lower tax rate than the ordinary income tax rate. An employee would make this immediate tax recognition election when the value of the stock is expected to rise greatly in the future.
Class F Common Stock
Class F stock is founders stock that is a unique class of common stock, which was generated by the Funded Founder Institute. This type of stock has become sufficiently common that I feel the need to explain it as part of this general venture financing lecture series. In startup ventures, the corporation is likely to issue preferred shares to investors. These preferred shares offer numerous control and financial protections to investors. The class F stock is similar to preferred shares in they they provide special voting and protective provisions that are favorable to founders.
- Voting – Generally, class F stock will have 10 votes per share, rather than 1 vote per share characteristic of traditional common stock. This is a “super-voting” characteristic and is common in companies where the founders highly value close control regarding outside equity investors.
- Protective Provisions – Regarding protective provisions, the class F stock may have any number of protective provisions common to preferred shares. Most commonly, the articles of incorporation or bylaws will require that certain shareholder actions require a majority vote by class F shareholders.
- Directors – The class F stockholders have authority to elect one director, who has 2 votes in comparison to the one vote of other directors.
- Participation – The Class F common stock and the Class A common stock otherwise participate equally with respect to dividends and distributions and other economic rights.
- Conversion – The Class F common stock can be converted into Class A at any time at the option of the holder, and will automatically convert if the holder dies or if the Class F common stock is transferred to someone other than another Class F holder or an entity for the benefit of a Class F holder.
Class FF Stock
Series FF stock is yet another variation of founder’s stock that has characteristics similar to a preferred class of share. The FF stock was originated with the Founders Fund, as part of their investment deals. As with most startup ventures, the FF class has been employed in Delaware corporate charters. The most notable characteristics of the class FF share is that: 1) it can be converted into regular common shares at any time, and 2) may be converted into a later class of preferred shares at a future equity financing round. The conversion into preferred shares allows the founder the ability to liquidate her shares, which is generally not the case for shares held by early founders. The conversion right into preferred shares only arises in the event of follow-on financing at some future date. The founder may elect to convert the FF class shares as part of the equity financing. The shares convert into the new class of preferred share offered as part of that financing round. Similarly to preferred shares, there is a mandatory conversion clause that forces conversion of the shares into common shares upon certain events (such as company sale or IPO). There are additional limitations on the ability to convert the shares, as follows:
- The purchaser must pay the same price for the class FF share as she or other investors pay for the preferred class of share, and
- The board must approve the conversion, or
- A majority of the class FF shareholders must consent to the conversion.
Generally, the number of class FF shares that may be converted in any financing round is capped at a set percentage of the total shares issued in the equity financing round. If the above conditions are met, the new holder of the class FF shares has the conversion option.
Concerns with Class FF Stock
Creating a unique class of stock with varying rights creates numerous issues for the business. For example, the class FF shares, like other common shares, will be exchanged for value. If the shares are issued at formation then the valuation is simply the par value (as the business has no operations and little value). Once the business is funded or has operations generating revenue, the business has substantial value. The founders will have to pay the equivalent value for these shares, or they will be taxes on the reasonable value of the shares as compensation from the corporation. Further, the class FF shares may be difficult to value given their diverse features. The value is obviously greater than regular common stock thanks to the greater liquidity and control rights, but that difference may be difficult to establish. Establishing the class of stock is not as simple as copying the founder’s fund certificate of incorporation. It will require custom drafting in the bylaws, subscription agreement, and any shareholder agreements. The board may have reservations about allowing the conversion of their shares to preferred stock. It can send a negative message to potential investors and it does not introduce new funds into the company. Lastly, investors may cram down any class FF liquidity rights in later funding rounds. Pressure from investors may cause the founders to accept a modification of the rights afforded by the class FF shares.
Stock Vesting Schedule
Early business ventures typically reorganize into corporations. The purpose of reorganizing is to establish a formal business ownership and management structure, as well as establish classes of ownership interest that can be efficiently transferred. As previously discussed, founders generally reserve some form of founder’s stock for themselves. Ownership of these shares may not vest all at once; rather, it may be made subject to a vesting schedule. A common vesting schedule is that shares will vest fully over 3-4 years. There is commonly a “cliff” or time frame before any shares will vest. For example, the first lot of shares may not vest until 6-12 months of services. Afterwards, the shares may vest monthly or quarterly. The start date for determining the vest date can be the date that the shares are issued or it can be an earlier date. Sometimes the founders will identify an earlier date to account for the work already invested in the business.
The vesting schedule protects the corporation in the event the founder decides to exit the corporation. If the shares have not yet vested, then the shares are either forfeited or the corporation is responsible for repurchasing them from the exiting founder. The requirement for the company to repurchase the shares of exiting shareholders is generally contained within the bylaws and the subject of a buy-sell agreement between the shareholders and the corporation. Equity investors will generally require that stock awards to founders or new employees be subject to such a vesting schedule. This prevents the issue of significant shares of the business being held by third parties who are not materially involved in the business. Founders, on the other hand, will seek to have unvested shares to vest upon exit or termination from the business. The middle ground is that the shares vest if the founder is terminated “without cause” and they are forfeited if the founder leaves or is terminated “for cause”. Of course, the “for cause” and “without cause” classification can cause serious disputes between founders and the business.
- Note: A middle ground between full vesting and no vesting is partial vesting. Acceleration of vesting for “without cause” termination may be a partial acceleration of say 3-12 months. This amount may constitute a valid severance package for the departing founder, as most startups have a buy-sell agreement in place that requires the corporation to immediately repurchase outstanding shares upon the separation of a shareholder.
Vesting Schedule & Follow-On Financing
As discussed in prior lectures, investors will seek to use a fully diluted capitalization calculation when investing in a startup. This includes the shares issued but not fully invested in founders. As such, the founders may want all unvested shares to vest at the time of investment in order to add increased certainty to the capitalization calculation. This is known as a “change-of-control” vesting provision. It is triggered when either the business is sold or equity investors acquire a controlling interest in the company. This provision protects the founders in the event that the investor’s influence will seek or cause the founder to leave the business. Investors do not favor these provisions, as it may diminish the incentive that the founders have in working for the business. As such, the corporation may need to offer options or some form of earn-out arrangement to incentivize the continued performance of these founder employees. Investors will also argue for increased stipulations on the “change-of-control” vesting provision. For example, the investor may include a requirement that the founder is fired without cause or there the conditions effectively force the founder out of the business within a stated period following the change of control. Effectively forcing out a founder/employee is known as “constructive termination”.
- Note: Expect investors to force a vesting schedule onto founders as a condition at the time of financing.