Incorporating your new startup is an exciting milestone. For founders, legal incorporation provides a new level of liability protection by separating business assets from personal assets, enables more legitimate capital raising potential, and establishes perpetual existence of the business entity itself.
Incorporating also boosts the company’s credibility and professional reputation.
Becoming a legal entity with incorporation provides another major advantage for startups: the ability to share company ownership by issuing shares of stock. While filing the appropriate legal documents can seem daunting, deciding how many shares to issue – and who to issue them to – is often a challenging decision to make.
Let’s take a look at how startups typically decide how many shares to issue, and how appropriate allocation is determined.
What Are the Different Types of Stock?
Preferred Stock
As startups seek capital from investors, they will need to issue preferred stock. This type of stock protects investors by prioritizing their repayment during scenarios like a merger or even a bankruptcy, where common stockholders face the possibility of losing their shares. During an IPO or acquisition, these shares can convert to common stock.
Common Stock
Every corporation is required to have common stock as the foundational building block of the company’s ownership structure. This common stock represents the core economic and voting ownership of the startup. Founders can establish multiple classes of common stock, sometimes including voting rights, 10X voting rights, or none at all.
Founder Stock
A subset of common stock, founder stock shares are initially priced very low, and they typically vest over time. When paired with an 83(b) election, purchasing shares at the initial low valuation allows founders to avoid ordinary income tax as shares appreciate. Vesting ensures the team remains committed to the company for a designated period of time. At the end of this period, also known as a cliff period, the shares become realized and founders begin to see actualized value.
What is the Difference Between Authorized and Issued Shares?
Authorized Shares
The total number of shares the corporation is legally authorized to issue are the authorized shares. This is often a misunderstood factor when determining equity. The number of shares to authorize matters less than the ratio of shares issued; whether the company authorizes 10 or 10 million shares, the size of the pie remains the same. It’s the value of each share (or the size of the pie slice) that changes, but they add up to the same total value. The numbers are largely about perception.
Issued Shares
The issued shares are the slices that were actually distributed. Shares that have been granted by the startup to founders, employees, or partners are issued shares.
Outstanding Shares
Technically, outstanding shares are a subset of issued shares. Shares that are outstanding are in circulation for trading purposes, and exclude shares the company holds on its balance sheet.
How Should Founders Determine the Number of Authorized Shares?
Early-stage companies must determine an appropriate number of shares to authorize. These shares will be the total number of shares that represent the value of the company, though the actual financial value is less important at this phase.
Authorized shares may not necessarily be immediately issued; rather, some equity shares should be set aside for future use. As the business grows, shares represent equity compensation for future investors, employees, or advisors, and startups are smart to ensure enough shares remain available to leverage as tools for future growth.
As a general rule, startups generally authorize millions of shares upon incorporation. This large number accounts for two main considerations:
- Large numbers of shares make equity grants feel more meaningful. If the startup authorizes 5 million shares and offers 5,000 as equity to an individual, 5,000 shares sounds much more impactful than 0.1% of the company.
- Increasing the number of authorized shares down the road requires board approval and legal filings. Authorizing a large amount of shares in the early stages can prevent the need for major cap table restructuring later in the lifecycle of the company.
What is the Right Number of Authorized Shares for My Startup?
Across various online resources and platforms, founders often see “10 million” as the appropriate number of authorized shares for startups. Here at HJF Law, we understand that each and every startup is different, and what works for one company may not apply to another.
As a team of experienced startup attorneys, our passion is to support the success of your business. A big part of what we do is ensure startups are set up for success from the beginning, including helping founders determine the right number of shares to authorize upon incorporation.
Remember, it’s never too early to hire a lawyer! Securing legal counsel at the earliest stages of your startup ensures smooth progression through the lifecycle of your business.
If you’re thinking about incorporating and are thinking about how many shares your startup should authorize, contact us here or call (917) 726-8184 to see if we’re a good fit for you.