What does it mean for shares to be authorized?
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.
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.
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:
How many shares then should the founders issue to themselves initially?
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:
Inna
Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved.
No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s).
Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply.
Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST.
Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.
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.
Generally speaking, unless the company is being incorporated concurrently with taking an investment, only Common Stock needs to be authorized.
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.Total Gross Assets (as reported on the U.S. Form 1120, Schedule L) X (Authorized Shares / Issued Shares) X $0.00035.
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.
Happy company making!
LEGAL DISCLAIMER 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.
Showing posts with label cap table. Show all posts
Showing posts with label cap table. Show all posts
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.
Saturday, March 3, 2012
Cap Tables for Startups
Capitalization tables (referred to in the industry as “cap tables”) are not difficult to grasp. But first-time entrepreneurs are often caught off-guard when they are asked to produce a cap table by a prospective investor (or his lawyer) doing diligence on the company.
In this post, we’ll talk about cap tables, their purpose, and what should be included in a cap table both for internal and external viewing.
1. Purpose of a Cap Table.
A cap table is, first and foremost, an essential internal document of any corporation. It sets out ownership of the corporation, in terms of the numbers of shares (by class and series) and in terms of percentages that those shares translate into. Ownership percentages matter (1) any time a vote of the equity holders is required, (2) for calculation of dividends, and (3) in the event of a sale or liquidation of the company, where they are used to calculate distribution of proceeds.
In addition, a cap table is one of the first documents that a company will be asked to produce in diligence. Prospective investors will request a cap table because they need to understand what the shares they purchase represent in terms of percent ownership of the company. This goes back to voting control and to upside in a sale of the company. Investors (or their analysts) will run waterfall analyses using different potential valuations of the company on a sale to make sure the investment has a realistic chance of being a lucrative one. (Click here for more information about waterfall analysis.) The cap table with waterfall analysis (or with numbers based on future financing rounds) is usually referred to as a pro forma cap table.
2. Structure of a Cap Table.
A cap table is most frequently maintained in Excel, and is structured in several tabs. The first tab is a Cap Summary and looks something like this:
When speaking to prospective investors prior to a signed term sheet, a cap table request can be legitimately satisfied with a PDF of this tab alone. As you can see, the cap summary provides enough detail to enable investors to create pro formas and run waterfall analyses, without giving away potentially confidential or at the very least sensitive ownership information.
The full cap table kept by the company would have additional tabs for each of the issued classes and series of stock (e.g., Common Stock, Series A Preferred Stock, Series B Preferred Stock), a tab for the stock plan, and a tab for outstanding promissory notes with interest calculations, if any. Such tabs would break-down the ownership of the shares by stockholder, include vesting provisions for stock subject to vesting, and list stock certificate numbers and dates of issuance.
Most importantly, these tabs would have percent ownership calculations on a by-class, by-series and on a fully-diluted basis. This becomes especially important when a particular decision of the company requires the consent of the shares comprising at least 50% of the Common Stock, 55% of the Series A Preferred and Series B Preferred voting together as a class, 66 2/3% of the Series A Preferred, and 50% of the Series B Preferred. Having stock ownership laid out in a well-organized, easy-to-understand manner, allows an easy identification of the minimum necessary stockholders necessary to secure the required vote.
In this post, we’ll talk about cap tables, their purpose, and what should be included in a cap table both for internal and external viewing.
1. Purpose of a Cap Table.
A cap table is, first and foremost, an essential internal document of any corporation. It sets out ownership of the corporation, in terms of the numbers of shares (by class and series) and in terms of percentages that those shares translate into. Ownership percentages matter (1) any time a vote of the equity holders is required, (2) for calculation of dividends, and (3) in the event of a sale or liquidation of the company, where they are used to calculate distribution of proceeds.
In addition, a cap table is one of the first documents that a company will be asked to produce in diligence. Prospective investors will request a cap table because they need to understand what the shares they purchase represent in terms of percent ownership of the company. This goes back to voting control and to upside in a sale of the company. Investors (or their analysts) will run waterfall analyses using different potential valuations of the company on a sale to make sure the investment has a realistic chance of being a lucrative one. (Click here for more information about waterfall analysis.) The cap table with waterfall analysis (or with numbers based on future financing rounds) is usually referred to as a pro forma cap table.
2. Structure of a Cap Table.
A cap table is most frequently maintained in Excel, and is structured in several tabs. The first tab is a Cap Summary and looks something like this:
When speaking to prospective investors prior to a signed term sheet, a cap table request can be legitimately satisfied with a PDF of this tab alone. As you can see, the cap summary provides enough detail to enable investors to create pro formas and run waterfall analyses, without giving away potentially confidential or at the very least sensitive ownership information.
The full cap table kept by the company would have additional tabs for each of the issued classes and series of stock (e.g., Common Stock, Series A Preferred Stock, Series B Preferred Stock), a tab for the stock plan, and a tab for outstanding promissory notes with interest calculations, if any. Such tabs would break-down the ownership of the shares by stockholder, include vesting provisions for stock subject to vesting, and list stock certificate numbers and dates of issuance.
Most importantly, these tabs would have percent ownership calculations on a by-class, by-series and on a fully-diluted basis. This becomes especially important when a particular decision of the company requires the consent of the shares comprising at least 50% of the Common Stock, 55% of the Series A Preferred and Series B Preferred voting together as a class, 66 2/3% of the Series A Preferred, and 50% of the Series B Preferred. Having stock ownership laid out in a well-organized, easy-to-understand manner, allows an easy identification of the minimum necessary stockholders necessary to secure the required vote.
Happy company-making to all!
Inna
 | Inna Efimchik 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. |
LEGAL DISCLAIMER Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved. No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s). Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply. Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST. Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.
Tuesday, February 14, 2012
Speaking VC Speak: Waterfall Analysis
In evaluating an investment, investors will usually run what is known as a waterfall analysis. In layman's terms, they have to analyze their take if this company is sold for... $50,000,000, $100,000,000, $200,000,000, etc. When they compare this against what they think the company is likely to sell for, with room for error, they have an idea what multiple of their investment in the company they potentially stand to gain from such investment.
Let's use an example to illustrate this analysis. Suppose investors are purchasing $5,000,000 of participating preferred stock capped at 3x of their investment. For simplicity, let’s assume that the stock purchased by investors is the only preferred stock outstanding in this company. Let’s assume further that after the purchase, investors will own 5% of the company, on a fully diluted basis.
In our example, in a $50,000,000 sale, investors get $7,250,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $45,000,000], which isn't a bad return given that in our example the investors invested based on a $100,000,000 valuation.
If the same company sells for $100,000,000, on the other hand, the valuation at which the investors invested, investors get $9,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $95,000,000]. In case you are wondering why the investors get back more than they invested even if the valuation of the company doesn't change, the answer lies in the participating liquidation preference.
Let's now consider a $200,000,000 exit. At this price, the investors receive $14,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $9,750,000], an almost 3x return on their investment.
What about if the company in our example sells for $350,000,000, a much better outcome for the investors? In that case, the investors’ return is $17,500,000 [5% of $350,000,000 because they would be above their cap for participating with the common stock and would opt for a return on a converted to common stock basis].
A basic understanding of waterfall analysis can be helpful for an entrepreneur in discussions with prospective investors.
Let's use an example to illustrate this analysis. Suppose investors are purchasing $5,000,000 of participating preferred stock capped at 3x of their investment. For simplicity, let’s assume that the stock purchased by investors is the only preferred stock outstanding in this company. Let’s assume further that after the purchase, investors will own 5% of the company, on a fully diluted basis.
In our example, in a $50,000,000 sale, investors get $7,250,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $45,000,000], which isn't a bad return given that in our example the investors invested based on a $100,000,000 valuation.
If the same company sells for $100,000,000, on the other hand, the valuation at which the investors invested, investors get $9,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $95,000,000]. In case you are wondering why the investors get back more than they invested even if the valuation of the company doesn't change, the answer lies in the participating liquidation preference.
Let's now consider a $200,000,000 exit. At this price, the investors receive $14,750,000 [$5,000,000 return of their investment + 5% of the remaining sale proceeds of $9,750,000], an almost 3x return on their investment.
What about if the company in our example sells for $350,000,000, a much better outcome for the investors? In that case, the investors’ return is $17,500,000 [5% of $350,000,000 because they would be above their cap for participating with the common stock and would opt for a return on a converted to common stock basis].
A basic understanding of waterfall analysis can be helpful for an entrepreneur in discussions with prospective investors.
Happy company-making to all!
Inna
| | Inna Efimchik 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. |
LEGAL DISCLAIMER Copyright Notice. The copyright for all original content in this post and any linked files is owned by Inna Efimchik. All rights are reserved. No Attorney-Client Relationship. This post has been prepared by Inna Efimchik of White Summers for general informational purposes only. The information provided herein does not constitute advertising, a solicitation or legal advice. Neither the availability, transmission, receipt nor use of any information included herein is intended to create, or constitutes formation of, an attorney-client relationship or any other special relationship or privilege. You should not rely upon this post for any purpose without seeking legal advice from licensed attorneys in the relevant state(s). Compliance with Laws. You agree to use the information provided herein in compliance with all applicable laws, including applicable securities laws, and you agree to indemnify and hold Inna Efimchik and White Summers Caffee & James LLP harmless from and against any and all claims, damages, losses or obligations arising from your failure to comply. Disclaimer of Liability. ALL INFORMATION IS PROVIDED AS-IS WITH NO REPRESENTATIONS OR WARRANTIES, EITHER EXPRESS OR IMPLIED, INCLUDING, BUT NOT LIMITED TO, IMPLIED WARRANTIES OF MERCHANTABILITY, FITNESS FOR A PARTICULAR PURPOSE AND NONINFRINGEMENT. YOU ASSUME COMPLETE RESPONSIBILITY AND RISK FOR USE OF THE INFORMATION IN THIS POST. Inna Efimchik expressly disclaims all liability, loss or risk incurred as a direct or indirect consequence of the use of any information provided herein. By using any information in this post, you waive any rights or claims you may have against Inna Efimchik and White Summers Caffee & James LLP in connection therewith.
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