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Stock for Startups: A Primer

by | Jun 10, 2024 | Firm News

Headshot of Howard J Finkelstein

Howard Finkelstein, Founder, HJFLaw

HJFLaw’s Howard Finkelstein Answers Founders’ Most Frequently Asked Questions

Q: Why is stock so important to startups?

A: Stock is important because it’s an instrument that defines ownership rights in your company. At the end of the day, someone who invests in the company doesn’t own the company’s assets; you have the company’s stock. It’s a legal fiction that creates its own set of rights, but it’s a nice fiction because you wouldn’t want somebody with 10% of the company to be able to take 10% of the assets.

Q: What is common stock?

A: Common stock is just that: common, the basic unit of ownership. Every company needs to have common stock. It represents partial ownership of a company. You can have all kinds of variations in the rights of common stockholders, most frequently regarding voting/non-voting rights. However, the majority of common stockholders have similar rights, and common stock is uniform across the country.

Q: What is preferred stock?

A: A company starts with only common stock, and the founders and employees who have received stock through the equity plan are all common stockholders. As the company starts doing rounds of investment, VCs and other investors receive preferred stock.

Preferred stock pays dividends and comes with its own set of rights, most significantly, stockholders get paid first if the company dissolves (the “liquidation preference”). VCs receive “convertible” preferred stock, which gives them the added ability to convert their stock to common stock when the time is right. This is just the tip of the iceberg – preferred stock can have other features and keeps changing as the marketplace changes.

Q: What is the difference between authorized and issued shares, and why does my Certificate of Incorporation say I have such a high number of authorized shares?

A: Authorized shares are the shares that the company’s Board and/or stockholders permit the company to issue. If a company decides to issue a maximum of one hundred shares and actually issues fifty, it now has one hundred authorized and fifty issued shares. They can still sell fifty more shares.

While life may be simple with a maximum of one hundred shares, a company that intends to grow will want more authorized stock. A company will have more authorized shares than immediately necessary, so it has plenty of stock to issue to employees in sizeable chunks and key moments in its growth, such as when it acquires another company. The number of authorized shares can be amended for a few hundred dollars in Delaware, but filing an amendment costs time (as well as, in many cases, attorney fees, and it can raise eyebrows when an investor is doing due diligence. No one (except a lawyer billing hourly) likes to see ten or fifteen amendments to the Certificate of Incorporation, so it’s better to have more than less.

Q: What is par value and why it is kept so low?

A: Par value is a random number that fulfills a few purposes. One purpose is simply for accounting, which is why the par value is usually not zero. In Delaware, it’s also used to calculate the annual franchise tax a company must pay. If the par value is too high, the company’s franchise tax rate may be higher. That is one reason it is preferable to keep par value low.

Most relevant to the work I do with my clients, however, is that once you put a par value on your company’s stock, it bumps up against a restriction that you cannot sell your stock for less than its par value. As an example, let’s say a founder incorporated a company in an area that does not allow par value to be less than a penny. If the founder takes the typical one million shares, they will have to pay $10,000 for the purchase of that stock because the company cannot sell it below par value. That’s not ideal because, in our minds, the stock is not worth that much. That’s why the par value typically has four or five zeros after the decimal and before the one, as in $0.000001.

Q: Why does the founder get one million shares?

A: One million shares is an arbitrary figure, but it is an easy number to work with and standard in the startup space. The real reasoning behind this number is so the founder has some cushion for the potentiality of losing a percentage of their ownership. One million shares keep the founder in a controlling position while leaving room for more people to come in and take some stock. If there are multiple founders, each founder typically receives somewhere between half a million and one million shares.

Q: What is dilution, and should I be worried about it?

A: I compare dilution to growing old. You may lose some cells, but the cells you have are stronger. Initially, you have 100% of the issued stock of the company, but eventually, you are going to get diluted by investors and employees coming in and getting stock awarded to them. At the same time, though, the value of your stock is increasing. Many founders start getting concerned when they go below 75% ownership, but the founder of a growing company cannot maintain that level of ownership forever. It just means that more people want a piece of your action. You have a smaller slice, but it is a larger pie.

Q: What is a reasonable amount of dilution a founder should expect?

A: If a founder owns 100% of the shares initially, eventually they are going to get down to about 40% or 50% (if they are lucky) after several rounds of issuing securities. Forty percent might seem low compared to 100%, but a founder is still not likely to get outvoted on most issues at that level. One of the things we do is help the founders retain voting control even when they don’t have 50%. The truth is that every owner of a growth company must be prepared to be diluted because the goal is to have sensible investors come in.

Q: How do I determine how many shares to issue to C-suite employees?

A: Some people will say that a chief marketing officer or a chief engineer should receive a certain percentage, but I find that imposing a rule is difficult because every company is different, and every employee is different. Some companies are willing to take a risk on people with less experience. Some companies want to entice hires from Google or Facebook and are willing to offer a higher percentage. It’s all about the negotiation.

Q: Should the stock I issue be vesting?

A: There is one main reason for vesting, which is to ensure the company gets the full value of its employees without issuing stock prematurely. Let’s say you’re a founder and you want to bring in a hotshot CTO. You know you must give the CTO stock, but you worry that they will take the stock and walk out the door the next day. This is when it makes sense to require a vesting period. If the CTO leaves the company before a certain amount of time has passed (known as the cliff period), they won’t get any stock. Once the cliff period has passed, their stock will begin to vest.

Q: Does vesting stock have any tax impacts?

A: Obviously, you want the value of your stock to increase, but the unfortunate thing is that if your stock increases in value from $10 to $1 million, that million dollars will be taxed at the ordinary income tax rate, not the capital gains rate. The solution is the 83(b) election, which is an IRS provision that allows you to pay income tax on what the stock is worth when you first receive it. When the stock vests and you sell it, you either get a long-term or short-term capital gain, depending on when you sell it.

Q: Who should be on my board of directors?

A: There is a lot of variation, but my advice is usually that your board of directors should simply be the founders until your first round of investing. Even with three or four founders, you shouldn’t get deadlocked on any vote (and if you do, you know you’re already in trouble). As the company grows, you’ll need to add people who represent the investor class. People with different interests will inevitably join the board, but limiting the board to founders in the initial stages makes things run more smoothly. This also plays into a very key rule that founders need to learn – keep distractions (like Board meetings) to a minimum, so you can focus on getting your product developed and in the market.