Friday, June 28, 2013

Getting to a Reasonable Cap Table: How Many Shares to Authorize Initially? What Classes of Shares to Authorize? How Many Shares to Issue to Founders?

A new corporation is formed when a Certificate of Incorporation in Delaware (or Articles of Incorporation in California and most other states) are filed with the Secretary of State. The Certificate of Incorporation must specify the total number of shares of each class that the corporation is authorized to issue. The Certificate of Incorporation does not specify how many shares the corporation has issued or who the stockholders are.

What does it mean for shares to be authorized?
Vocabulary is important here. The authorized number of shares that goes in the Certificate of Incorporation is the number of shares that the Board of Directors may issue without amending the Certificate of Incorporation. By contrast to authorized shares, issued shares are shares that have actually been sold and are outstanding.

Amending the Certificate of Incorporation to increase the authorized number of shares requires a vote of the stockholders of the corporation. It also requires a state filing and associated fees. This is somewhat tedious. When thinking about the number of shares that you need to authorize, plan so that number of shares initially authorized is sufficient for your purposes for the foreseeable future, until a significant event in the life of the corporation, such as a financing, for example, when you will go through the trouble of amending the Certificate of Incorporation.

What classes of shares should be authorized initially?
Generally speaking, unless the company is being incorporated concurrently with taking an investment, only Common Stock needs to be authorized.

While online searches for sample Certificates of Incorporation may return some Certificates of Incorporation with "blank check" Preferred Stock, the best practice for a startup is not to include it. Investors keep a close eye on the company's authorized and unissued shares of each class and series, allowing only a very small cushion.

This is because a stockholder's share in a company is calculated as such stockholder's shares divided by the sum of all issued and outstanding shares of the company and the shares reserved under the company's stock plan. Note that a stockholder's share is not based on the company's authorized shares. Therefore, if a significant cushion exists, an investor's share can be easily diluted by the company issuing shares from the pool of authorized shares, without seeking the investor's consent.

While most investors expect to be diluted at some future time, for example, in connection with the next investment into the company, they try to structure their investment in a way to delay the dilution to a time when the value of the company has increased as well. To better understand dilution, read my blog post on dilution.

How many shares should be authorized initially?
For my startup clients, I typically recommend that 10,000,000 shares of Common Stock be initially authorized. There is no magic to this number, but it tends to result in a Series A price per share that is of a familiar/standard magnitude.

Typically, at a Series A stage, a startup is going to be valued between $2M and $12MM, broadly speaking. At the time of investment, the Series A price will be calculated as pre-money valuation divided by the total number of then issued and outstanding shares, plus the shares reserved under the company's stock plan (including an increase to the stock plan reserve for the Series A round). Simplistically, a $10MM pre-money valuation, divided by $10MM shares (which include shares already issued to the founding team and the unissued shares reserved under the stock plan), equals a Series A price of $1.00. Individual numbers will vary of course, but it makes it easy and convenient to stick to conventions, so that the Series A price per share isn't 1/100 of a dollar nor hundreds of dollars.

There is an additional consideration. When a startup is recruiting, optically, it is better to be offering 15K, 30K, or 75K shares to employees than 15, 30, or 75 shares. It requires an additional conversation with the recruits about the company's capital structure, about the number of shares that are authorized, and about why that is the case. Most likely, a company that starts out with a very small number of shares will end up doing a stock split at a future point. It's not particularly difficult, but it complicates matters. If you can authorize the "correct" number of shares from the start, the number that will make your life easier, why wouldn't you?

I recently heard from a company that was incorporated by their CPA, that they were advised to authorize no more than 5,000 shares. The logic behind this suggestion was to save the company money on Delaware franchise taxes. It is true that using the "authorized shares method" a company's franchise tax liability can be as low as $75.00 per year for so long as the company does not authorize more than 5,000 shares. And for a regular small business (not a startup), that's a perfectly acceptable logic to follow. But startups need room to grow. No VC will understand the logic behind keeping the authorized share number extremely low to save a couple hundred bucks. It will seem very short-sighted to them, not smart and frugal. A typical startup uses the "assumed par value capital" method to calculate its Delaware franchise tax liability. The minimum tax that may be owed under the assumed par value capital method of calculation is $350.00. The actual formula to calculate franchise tax liability using this method can be simplified to the following:

    Total Gross Assets (as reported on the U.S. Form 1120, Schedule L) X (Authorized Shares / Issued Shares) X $0.00035.

How many shares then should the founders issue to themselves initially?
Founders have a very natural inclination to want to issue amongst themselves all the shares that they authorize in the initial Certificate of Incorporation. However, if the company plans to use equity in the near-term to incentivize its consultants and employees, then a reserve of authorized but unissued shares should be left for this purpose. A typical reserve, even without a formal stock plan, is 10-30% depending on the company's hiring plans. So, in our typical scenario, the founder or the founders would be issued, in the aggregate between 7M and 9M shares of Common Stock, with 1M to 3M authorized and unissued shares remaining available for future issuance.

Note that the share reserve needs to be sufficient for the company's hiring needs until the next time that the Certificate of Incorporation is amended, and as we've said before, a natural time for the Certificate of Incorporation to be amended is in connection with an equity financing.

Finally, just a reminder that for founder shares to be properly issued, the following formalities should be observed:

  • there needs to be board authorization (either at a meeting or by written consent) for the issuance,
  • there should be a stock purchase agreement (preferably with vesting) documenting the sale and issuance of the shares,
  • there must be consideration in some form paid for the shares (by assignment of technology is very common),
  • stock certificates should be prepared and signed to evidence ownership of the shares (but kept in escrow by company secretary, and not distributed to the stockholder, if the shares are subject to vesting),
  • the sale should be made in compliance with both a federal and a state securities exemption (which sometimes require a filing, like the Section 25102(f) filing in California), and
  • there may need to be a 83(b) filing made as well, if shares are being issued subject to vesting.

Happy company making!


White Summers  Inna Efimchik, a Partner at White Summers Caffee & James LLP, specializes in assisting emerging technology companies in Silicon Valley and beyond, providing incorporation, financing, and licensing services as well as general corporate counseling.

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