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