Issuing Equity Causing Issues? Here Are Some Legal Guidelines.
Allocating equity among co-founders can be tricky. Our friends at Cooley outline a few things to consider.
By: Josh Rottner & Pat Mitchell, Cooley LLP
This post is part of “A Rough Draft of the Legal Basics,” a series covering the legal basics every startup needs to cover.
So you’ve decided that it’s time to form a legal entity and are now trying to determine how to allocate equity among your co-founders. Below is a brief overview of the things you should be aware of as you make these decisions.
To keep our posts to easily digestible chunks, this post covers only the conceptual issues to be aware of when issuing initial founders’ equity. In future posts we’ll cover both the mechanics and technical issues to be aware of for founder equity grants, as well as items to consider when issuing options and other forms of equity to employees, consultants, directors and other service providers.
1. What is “equity”?
“Equity” is a generic term that people use to refer to a security representing ownership of a company.
- In a C Corporation, which is typically the preferred form of entity for a company seeking venture capital investment, equity will be issued in the form of shares of a corporation’s capital stock, however other organizational forms have different names for their equity interests.
- In general, equity represents a person’s right to vote on certain matters relating to the company and that person’s entitlement to a portion of the company’s profits and assets in certain circumstances.
- For venture-backed companies, when people use the term “equity”, they are often also referring to options to buy stock. Options are not outstanding shares of stock, rather they are a contractual right to purchase shares of stock in the future at a set price. Since the holder of an option has the right to exercise the option for actual shares (which would be dilutive to the existing stockholders), companies generally think about issuing options in the same manner as they think about issuing shares of stock.
2. How much equity can I issue?
In a Delaware C Corporation, Delaware laws require each company to set a maximum number of shares of each class of stock that the company is authorized to issue, and the company can’t exceed that number without the prior approval of the company’s board of directors and stockholders, as well as a filing with the Delaware Secretary of State. To keep things simple at the outset, when forming a company we generally recommend authorizing a nice round number like 10 million shares of common stock, and then issue 8 million of these shares to the founders while leaving the rest available for future issuances in case the company needs it (depending on the circumstances, we’ll sometimes instead authorize 5 million shares and issue 4 million, though the concept is the same in each instance). While there’s no legal magic in these particular numbers, here’s why we suggest them:
- Having a sufficiently large number of outstanding shares provides the company with the flexibility to allocate very precise percentages of equity, which might not be possible if an equity grant is rounded to the nearest share and there are a small number of shares outstanding.
- When seeking investment from venture capitalists in the millions of dollars, having a larger number of authorized shares will cause the price per share to be in a range that people are comfortable working with (such as cents or single digit dollars), rather than having each share worth huge sums.
- There is some psychology involved: when issuing shares, we’ve seen that issuing a large number of shares in nominal terms to an individual has the effect of making them feel invested in the company, even though intellectually they know that their actual economic benefit depends instead on their relative ownership vis-à-vis other stockholders.
- A secondary or tertiary consideration is that in some circumstances, the annual or quarterly franchise tax owed to the State of Delaware to keep your corporation current can be based on the number of authorized shares. For a quick primer on calculating and minimizing Delaware franchise tax published by our colleagues at CooleyGo, please see: So You Owe Thousands of Dollars in Delaware Franchise Tax?
3. How do I decide how much equity to issue to the founding team?
Once you’ve picked a number of shares to authorize and issue, then you need to decide what portion of the issued shares should go to each founder. While it’s easy to say that all founders should have equal shares, achieving an optimal result usually requires quite a bit of planning.
As an overarching point, we generally advise our clients to think carefully about the relative values of each individual’s contribution when setting the number of shares that they receive. One analogy that we like to use is that in the band the Beatles, John Lennon was much more valuable than Ringo Starr — so if we were allocating equity among the four Beatles, we would recommend giving Lennon a much bigger share than Starr. This concept of relative contributions can be applied to founding teams. For more information about the types of issues founders consider when allocating equity among themselves from CooleyGo, please see: How to Allocate Stock to Founders and Other Early Team Members.
4. Do we really need vesting? We all want to keep our shares!
If you are part of a founding team involving more than one founder, how would you feel if one of your co-founders leaves the company for another job the day after the company is formed, and still owns as much equity in the company as you do? Without vesting, a founder that leaves the company will get to keep all of her or his shares (even if they only worked for the company for a very short time), which often is a source of frustration for the remaining founders who took the risk of foregoing other lucrative opportunities of their own to build the company.
Also, if you expect to seek funds from venture capital investors, the venture capital funds are very likely to ask that all founders be subject to vesting as a condition to investing. Even though it’s possible to wait until the venture capital investors ask for vesting at the time of a financing, we generally advise our clients to strongly consider vesting from the outset because the company’s investors are almost certain to require vesting at the time of a financing, so it may be beneficial to propose something that is acceptable to the founding team upfront.
While there are an endless number of vesting schedules, the most commonly used vesting schedule for venture-backed companies is vesting over a four year time period beginning with the date that the founder starts working for the company, with a one year “cliff” — meaning that no shares vest until one year has elapsed from the date that the founder started working for the company, then 25% of the shares vest on the founder’s one year anniversary with the company, with the remainder of the shares vesting in equal monthly or quarterly installments after that. In addition, sometimes founders receive “acceleration”, meaning that some or all of their shares vest early in the event that the company is sold or in certain other circumstances.
Background of the series “A Rough Draft of the Legal Basics”
As start-up lawyers, we spend our days working with talented, passionate and courageous entrepreneurs creating cool things. Our clients are on the cutting edge of software, social media, energy, ecommerce, robotics and space exploration. As companies mature, they face a variety of legal issues depending on their industry, strategy and stage of development. But at the very beginning, almost all start-up clients have similar legal needs and tend to ask the same questions. We have advised many companies (including some in the Rough Draft program) on these basic legal questions, and will be sharing our answers with the Rough Draft community in a series of posts on this site. This is part 2 in a series of posts on this site relating to these basic legal questions. Click here if you missed Part 1: Forming a Legal Entity.