Tag Archives: common stock

What is a Fully-Diluted Basis?

The concept of a fully-diluted basis is not difficult. A fully-diluted basis just means the assumption of the highest potential amount of common stock a startup will have outstanding, regardless of vesting provisions and assuming all options and other securities like convertible notes are converted into common stock. That is, assume the highest share count possible.

I’ve seen it defined in legal documents in the following way:

Fully-Diluted Basis” shall mean the assumption that all options, warrants or other convertible securities or instruments or other rights to acquire Common Stock or any other existing or future classes of capital stock have been exercised or converted, as applicable, in full, regardless of whether any such options, warrants, convertible securities or instruments or other rights are then vested or exercisable or convertible in accordance with their terms.

The definition of fully-diluted basis matters especially for founders in financings. Typical VC financing deals will calculate the Series A share price on a fully-diluted basis, and the investors have an incentive to capture as much shares as possible in the definition of fully-diluted basis. The larger the amount of shares calculated by the definition of fully-diluted basis, the lesser the Series A share price.

Par Value for a Startup Company’s Stock

Par value is the minimum price that a corporation can issue its shares.  In the US, par value was created during the time of the great depression in order to ensure a shares could not be sold under a certain price.  Today, that concept is somewhat archaic, but it still plays an important role and should be thoughtfully considered when forming a startup company by filing the certificate of incorporation.

While I typically see either $1 or “no par value” common stock when looking at new client startups that have incorporated on their own or via an online service, I typically recommend that a startup corporation’s Common Stock par value be set at $0.00001 and no higher than $0.0001 per share.

My recommendation is based on my belief that startups should authorize 10,000,000 shares of common stock upon filing the its charter. The startup will then typically issue about 6,000,000 to 8,000,000 shares to its initial set of founders (as there is a reserve usually kept for initial/short term issuances to people like employees, consultants and advisors).

Therefore, if your startup issues 7,000,000 shares with a $0.0001 par value to its initial founders, the minimum the founders would have to collectively pay for those shares is $700. Alternatively, if your startup issued 7,000,000 shares of such common stock with a par value of $0.00001 to the initial founders, the minimum the founders would have to collectively pay would be $70.  Whatever the setup, usually founders are not paying much out of pocket when it comes to purchasing their initial shares.

It’s also very important to set par value low when you authorize many shares in Delaware because this will help keep your franchise taxes low.  There can be drastic consequences, at least Delaware franchise tax bill wise, if you set your par value high and your authorized shares high.

Update: If you are looking for more information about incorporation, check out my “If I Launched a Startup” article.

How Many Shares of Authorized Stock Should a Startup Company have at Incorporation?

An often overlooked aspect of filing a certificate of incorporation is determining how many shares of authorized stock should the new corporation authorize at incorporation. This decision doesn’t really matter to most businesses (I don’t have a clue how many shares I authorized when I incorporated my law firm), but startup companies aren’t like most businesses. Most businesses don’t grant stock options or seek venture capital. Thus, the organization and capitalization of your startup is important from the outset, and this all begins with how many shares of authorized stock your startup authorizes.

The short answer: 10,000,000 shares of Common Stock

The number of shares of authorized stock to authorize at incorporation is somewhat arbitrary, but my preference is to authorize 10,000,000 shares.  And this type of stock is usually ‘plain vanilla’ Common Stock and not something like dual class common stock for founders.

Are these 10,000,000 shares issued at incorporation?

Now, that doesn’t mean all 10,000,000 shares of authorized will be issued to the founders immediately upon incorporation. The startup must be careful and select an amount of authorized stock that will account for your startup’s short-term planned issuances and the reserved stock option pool — at least for the short term. Otherwise, your startup will have to incur additional filing and/or legal fees to increase the shares of authorized stock once you reach the maximum.  It’s not going to break the bank, but it can be discouraging to incur another $250 in just filing fees because your startup used up all its authorized stock so quickly.

For example, say you authorize 10,000,000 shares. You may want to keep a reserved option pool of 1,000,000 shares, thus you would only issue up to 9,000,000 shares to the founders. But we usually recommend that a startup issue about 60% of its authorized shares at incorporation.

Why 10,000,000 and not 100,000?  Or 1,000,000?

Of course, you could obtain the same result by authorizing 1,000,000 shares with an option pool of 100,000 and a 900,000 common stock issuance to the founders. But for some reason, people (and when I say people I mean the developers/consultants/directors getting the stock options) like to have a larger number of stock options even if the percentage of the company would be the same. I guess 50,000 stock options sounds better than 5,000 when you are up in the club.  And vanity does play a part…sometimes.

Note:  Delaware calculates franchise taxes in two ways, either by the total amount of authorized shares or by the assumed par value capital method.  Most startups (especially those that authorize 10,000,000 shares) should choose the later method — and should not freak out when Delaware sends the annual franchise tax notice.

Pro and $$$ Saving Tip:  Set your par value low.

Update: If you are looking for information about startup company incorporation, check out my “If I Launched a Startup” article.

What is Preferred Stock?

Most startups issue only common stock. But sometimes a startup will encounter a situation, such as raising capital, where having more than one class of stock is beneficial (or required). When startup companies raise capital through the issuance of stock, they typically issue “preferred stock” to their investors.

Definition of Preferred Stock

Preferred stock is a class of stock that provides certain economic and control rights and protections not given to the holders of a startup’s common stock (the founders usually hold the common stock). Hence this class of stock is “preferred.”

Typical economic rights of preferred stock include a liquidation preference, anti-dilution protection, and conversion rights. Control rights deal with a host of voting issues and electing the board of directors.

Which Investors Receive Preferred Stock?

Preferred stock is most commonly issued when a startup undergoes a large financing, such as one with a venture capital fund. Angel investors and the friends & family round may sometimes receive preferred stock. Keep in mind there is no bright-line rule when it comes to angels and the f&f round.

Other than the Capital Raised, Does the Startup Benefit from the Issuance of Preferred Stock?

It sure does. Since preferred stock comes with economic and control rights and protections, common stock typically gets a lower valuation for the purposes of stock option grants or share issuances to the corporation’s employees. Employees can generally exercise their common stock options at a lower price than the price of the preferred stock. Thus, employees may feel as though they are receiving some sweat equity for their contribution to the corporation.

Why Your Startup’s Founders Stock Should Vest Over Time

If your startup company launches with more than one founder and your startup plans to eventually be acquired or seek venture funding, your startup’s founders stock should vest over time according to a vesting schedule.

Founding teams might not stay together. And having a missing founder or two with a nice chunk of your startup’s common stock is not a scenario your startup wants when it comes time for an acquisition or venture capital financing.

So instead of the founders getting all their shares of common stock on Day 1, the founders get their stock according to a vesting schedule. The standard vesting schedule for startup companies is four years with a one year cliff and monthly vesting thereafter until the founders reach 100%. The one year cliff means that the founders do not get vested with regards to any common stock until the startup’s first anniversary. Thereafter, the founders get vested every month at an amount equal to 1/48th of the their total common stock.

If a founder leaves before the startup’s first anniversary, the founder leaves without any common stock. If a founder leaves after 15 months, the founder will have 31.25% of his common stock vested (25% after the first year, plus the 2.083% vesting each month for 3 months). Thus, the missing founder leaves the startup with much less shares than if the founders stock had vested immediately. This makes it easier to get the necessary approval (and other issues) to go forward with an acquisition or venture capital financing…not to mention allow you to spend that repurchased equity to new hires/founders.