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Types of Equity Discussion

You developed the next big app. You created the next trendy social media site.  You may have formed an entity and developed a big business plan.  Now how do you get the information and funding needed to grow this potential million-dollar project?

This article series will explain, in layman’s terms, some of the things that every founder should know about the types of company equity and the relation to common forms of funding.  In this text, I will be relying on the example of a C corporation for discussion purposes.  This advice can be applied to any type of business you see yourself starting.

Let’s start with some common definition terms that offer a good understanding of the basics.

Forms of Equity (Ownership Interest in the Company)

            Founder’s Stock– This is a generic term often used when dealing with startup companies.  This is the stock issued by the company to the founders of the company.  The most common way this occurs is that the corporation is formed and then there is a corporate resolution to issue a portion of the corporation’s authorized stock to the people who started the company.  They are usually issued in exchange for the founder’s initial services to start the company, for technology assigned to or developed for the company, or for some other thing of value, such as cash provided to the company.  It is pretty typical that a company issues common stock as founder’s stock versus preferred stock.  It is usually no different than any other type of common stock issued by the company, other than it was issued to those who founded the company.

The company will usually place some kind of restriction on founder’s stock, such as a vesting schedule over time, but this is not always the case.  This usually includes a right of repurchase or other clauses that deal with unvested stock.  These are usually put in place to avoid potentially negative tax consequences from deferred compensation.  Just because there is a vesting for founders’ stock, it doesn’t indicate there is mistrust; it can often be to protect a founder from these adverse tax consequences.

The initial amounts of stock used for founder’s stock are determined by the company’s “capitalization.”  This means the total equity structure of the company, e.g., Company A has 1,000,000 shares of common stock authorized. 500,000 of these shares are issued to founders with no one else owning any other form of shares or options to purchase shares.  The founders would own 100% of the company even though the company can still issue more shares.

Common Stock– This is the general basic form of equity (ownership interest) in a corporation.  It is represented by a physical stock certificate (or in some cases, in electronic form with a broker).  It shows the name of the person or entity owning the stock, number of shares, name of the corporation, and sometimes other info like date of issuance, signatures by corporate officers, number of authorized shares of the corporation. It is issued to founders for many different reasons such as funding, or as compensation for services, etc.

People are curious what percentages are owned and by who.  In the capital structure of most corporations with only common stock, there are a certain number of shares authorized to be issued by the corporation, which is typically found in places like the articles of incorporation, board resolutions, or in documents filed with the secretary of state in the state of incorporation.  Authorized shares are the pool of available stock the company can issue to people now or in the future.  The number of shares actually issued to people is the amount of stock outstanding.  So, if there are 100 shares authorized, but only 10 shares issued, only 10% of the potential ownership of the corporation has been issued.  If you own 10 shares of the corporation, right now you own 100% of the company.  If the company issues another 90 shares to someone else, you now only own 10% of the company’s now issued 100 shares of stock.  When seeking equity funding, you are selling a portion of the company’s shares of stock.  This almost always results in you owning less of the company.  The only way to keep your percentage the same would be to sell the stock you own (not the company issuing new stock) or for the company to issue you more shares of stock to keep your total percentage of the company the same (called anti-dilution, so you are not “diluted” down).  Now most investors are not going to want to line your personal pockets by buying your personal stock, they want to help the company grow and get a percentage ownership; therefore, they are usually going to require that you be diluted down.

Don’t always assume you are losing control of “your” company or that you are getting somehow duped.  First, a corporation is a separate legal entity owned by its shareholders, so although you may own 100% of the shares right now, it is best to get out of the habit of thinking it is “your” company.  Also, as an example we can look at Mark Zuckerberg, Founder and CEO of Facebook, who was diluted down in shares (although surprisingly not much), and he remained successful.  He still maintains control of the company through board seats and voting agreements/proxies, but that is another topic entirely.  You will be diluted down and probably lose 100% control over the company, but if you want to receive funding, it is part of the deal, especially in the venture capital world.

Restricted Stock– This term is a designation that can apply to any type of stock and usually specific restriction is required to be printed on the physical stock certificate so that the shareholder knows about it.  This usually means that the stock has some form of restrictions on transfer, meaning you cannot sell it without complying with those specific restrictions.  Common stock, founder’s stock, or preferred stock could all potentially be labeled restricted stock (any usually is).  If you go onto your online stock brokerage account and buy 100 shares of Microsoft, you are buying freely traded, unrestricted, common stock.  In other words, there are no restrictions on transfer.  In most cases with startups, the initial stock is going to be restricted.  You can only sell the stock after it is registered with the SEC (“goes public”) or there is an exemption that allows you to sell freely.  SEC Rule 144 is a rule regarding the holding period that you must hold the restricted stock in before it can become free trading stock.

Preferred Stock– Preferred stock can come in many forms, but usually has greater rights and preferences than common stock.  Despite this, it is still issued in the same fashion as common stock.  In a liquidation of the company (say for a bankruptcy), preferred stockholders get paid out before common stockholders if there is anything left to distribute to stockholders.  There are also many other preferences, rights, and privileges that can apply to preferred stock and even in some cases, the preferred stock can be converted into common stock.  These rights and preferences are usually stated in the amended articles of incorporation.  You often hear of Series A, and Series B funding, pertaining to the rounds of funding with preferred stock.  Series A is preferred stock first, then Series B, then Series C and so on.  The rights and preferences, while lengthy and require lawyer consultation, are commonly things like conversion, anti-dilution, voting rights, board seats, and liquidation preferences.

Options & Warrants (not equity)- I mention warrants and options in this section as they are commonly associated with or attached to funding but are not technically equity.  An option or warrant is a contractual right to purchase stock in the future.  It is ruled by the grant, which is typically in the form of a written agreement with the company to issue stock upon the occurrence of some future event.  Examples of this are when the company goes public, gets more funding, or when the holder exercises the right to purchase the actual stock with cash.

I bring this up while discussing equity because options and warrants are technically “securities” which are covered by various securities laws.  They also affect the ownership percentages in the company.  The company’s accounting department is supposed to reserve stock for these future rights so that the company has enough stock to cover the options if they are exercised.  This is when you hear about the “fully diluted” amount of stock in a company, it typically includes things like stock that would be issued in the future if the person exercises the option.

Below is a graph that shows forms of funding/liquidation preferences with warrants/options being low on the scale of rights held by an investor, but more flexibility for the company.  The closer you get on the scale to straight debt (a loan), the more protected the investor usually is, but the company has less flexibility.

For any Equity queries please contact PLG Attorney, Chris Barsness at cbarsness@patellegal.com.

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