The easiest way to mess up when setting up your company

From the desk of the Grumpy Old Company Lawyer

One of the benefits we provide to participants in the Iowa Startup Accelerator is access to working capital. We have a relationship with a separate fund that provides cash for a portion of the startup’s equity. Before the fund invests, it generally requires the startup to be duly organized as a Delaware C-corporation. The company issues a small percentage of its common stock to the fund. Most startups hire a local attorney to set up the corporation, but others may use an online legal service, either for convenience, to save money, or because they are just “hands on” kinds of people.

Don’t get me wrong, there are great online legal services available, but the users are more-or-less on their own to decide how to set up the share structure. Here’s where a quick conversation with your company lawyer might be helpful.

On a recent due diligence questionnaire, in the box where we ask about the company’s Authorized Shares, the founder inserted “Yes.” (Sorry, for a corporate lawyer, this is about as funny as document review gets — made me snort my coffee.) While I could appreciate that the founder had indeed gone to the effort of having their shares properly authorized under Delaware law, I was really looking for a number. The correct answer in that case was “10,000,000.”

The next question was: Shares Issued. Answer: “10,000,000.” Houston, we have a problem.

With 10 million shares authorized and 10 million shares issued to the founders, they had none left to issue to investors (such as our fund), to future employees as stock incentives, or to those whispered angel investors we’ve all heard about.

There are at least two ways to fix this.

One way would be to revise the number of shares of stock issued to founders. Using the existing ownership percentages, reduce all the outstanding shares by a factor of, say, 1 for 10. Ta-da! Nine million shares of instant headroom. A 4,000,000 shareholder becomes 400,000, and so on. This is essentially a reverse stock split. Since there’s likely no market for the shares yet, there would be few adverse effects. This can also be done solely among the company and the founders. Publicity and filings would be minimal. The founders each still own the same amounts of the company, since it’s the issued shares that determine the voting power of each shareholder. See sample reverse stock split.

The other way to fix this is to increase the total number of shares of authorized common stock to allow for future uses and investors. This will require the board and shareholders to file an amendment to the articles of incorporation with the state of Delaware.

Keep in mind that you will need to check your Bylaws, prepare board and shareholder resolutions to increase the number of shares the company is authorized to issue, and file amendments with the state, including the requisite filing fees. See sample resolutions. Also, if you are registered in Delaware, your annual corporate franchise taxes will be based on your authorized shares and par value. It’s likely to add a few hundred dollars more per year to your costs if you double your authorized shares. The Delaware Corporate Division website has a handy calculator. https://corp.delaware.gov/taxcalc.shtml

How many more authorized shares should the company choose? If it has 10 million shares authorized, but all issued, what would make the most sense?

The answer depends on the growth prospects for the company, both in seeking new equity investors and providing employees with equity incentives. Also, the immediate need would be to ensure any outside investors who are standing by can get their shares. With 10 million already issued to founders, it wouldn’t be unusual to see a company with twice that number as a total authorized at this early stage. After that, you need to think further out: angel investors, venture capital firms, IPO? Actually, you don’t need to think that far out, because if you get to the VC stage, they’ll likely take you through a total overhaul of your cap table anyway.

Finally, don’t be afraid to talk to your friendly neighborhood corporation lawyer. These are common types of questions. Getting customized answers shouldn’t rack up big charges, and it will set you on the right path build that next big thing.

Sample reverse stock split resolutions

Sample increase authorized shares resolution

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This blog and the sample documents are for general information only, and is not intended to be, nor may be taken as personal legal advice. Consult a qualified independent corporation lawyer to help make sure you are complying with the laws and regulations in your jurisdiction.


Originally published at NewBoCo.