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.
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?
Friday, October 19, 2012
Startups: Choosing between an LLC and a Corporation
Almost everyone knows the core difference between a C-corporation and an LLC from a tax perspective -- LLCs get pass-through treatment (unless otherwise elected), such that all gains and losses of the LLC are recognized on the US tax returns of its owners (known as members). By contrast, C-corporations are treated as separate legal entities for tax purposes. Owners in corporations (known as shareholders) are not taxed on the corporation's gains and losses, though they are taxed individually if they receive a distribution (e.g., a dividend).
Very likely, you are reading this and thinking, "Yes, I know, but so what? I still don't know whether to form a corporation or an LLC." So let's see what this means for us.
I would posit that if you are a true startup (not a small business), the following will be very important to you: (a) being cost-efficient, and (b) obtaining funding from investors. If you agree with the premise and find yourself in that boat, read on.
Investors. Institutional investors (funds) will almost always require a company in which they are investing to be a C-corporation. There are several reasons for this:
- Administrative Burden. Investment funds are generally pass-through entities themselves, so their limited partners would be burdened with K-1 forms (the tax form which is issued to members in an LLC which allocates LLC's gains or losses to such member) for each investment by each investment fund in which such limited partner is participating.
- Tax Exempt Status. Some investment funds can't invest in LLCs because of their tax-exempt status or the tax exempt status of their limited partners.
- U.S. Tax Obligations for Foreign Funds. LLCs create a problem for foreign investors who may not otherwise be subject to US taxation or to US tax filing requirements.
- Structure. Investors like corporations because of the rigid time-tested structure that they provide. Corporations are owned by shareholders who vote for and elect a board of directors. The board of directors votes on important company decisions and, in turn, elects officers, who run the corporation day-to-day. The shareholders (among them the investors) have clear rights, among them, to remove the existing board and elect a new slate of directors if they feel that the corporation is getting derailed. LLCs are known for being more flexible. Rigidity can be built into them, at an extra cost, but is not inherent to this entity form.
Efficiency. In an LLC, the entirety of the understandings between the members as well as the ownership, management, and tax structures, are contained in a single agreement - the limited liability company operating agreement. This is a complex, difficult to understand, tax-heavy document, which requires much customization and deep tax expertise. This translates into many attorney hours and expensive tax counsel. On the other hand, corporate formation and financing use several smaller agreements, forms of which have become largely standardized over the years such that these agreements are actually faster and simpler to draft than the LLC operating agreement. Each corporate document has a narrow purpose, and because the corporation is a stand-alone legal entity, tax analysis for the members does not come in like it does in the LLC operating agreement. Faster, simpler, and no tax review all spell "cost-efficient".
Conclusion. For a typical startup that plans on raising capital, I think it's not worth spending a lot of time debating the pros and cons of different entity types. Bottom line is, forming a corporation will save you a lot of unpleasant discussions with investors down the road and, ultimately, the cost of converting your LLC to a corporation.
It goes without saying that there are exceptions to every rule. For instance, the founders may plan to bootstrap for several years and the LLC form would allow them to write-off operating losses during those years against their ordinary income from other sources. Or, a startup's capital may come from an angel investor who really likes the pass-through losses that he can take through his investment in an LLC. Or, friends and family investors may be providing capital with the idea of getting regular dividends, without double-taxation eating into the profits.
The above scenarios, however, are not typical startup issues, which is why typically, the right choice is to incorporate. But if you are in doubt or there is something unusual about your situation, you should consult a tax and/or legal advisor.
Happy company making!
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. |
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.