Howard Finkelstein, Founder, HJFLaw
HJF Law’s Howard Finkelstein Answers Founders’ Most Frequently Asked Questions
Q: Why is stock important to startups?
A: Stock is an instrument that defines ownership rights in your company. An investor doesn’t own the company’s assets; they own the company’s stock. It’s a legal fiction that creates its own set of rights separating company and asset ownership.
Q: What is common stock?
A: Common stock is just that – common. It’s the basic unit of ownership that every company needs to have. It represents partial ownership of a company. There are many 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 begins accepting rounds of investment, venture capitalists 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). Venture capitalists can receive convertible preferred stock, which provides 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 growing company will want more authorized stock. Having more authorized shares than immediately necessary provides plenty of stock to issue to employees in sizable 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, and in many cases, attorney fees. Multiple amendments can raise eyebrows when an investor is doing their due diligence. No one (except lawyers who bill hourly, unlike our retainer structure at HJF Law) likes to see ten or fifteen amendments to the Certificate of Incorporation, so it’s better to start with more authorized shares than less.
Q: What is par value, and why is it kept so low?
A: Par value is a random number that fulfills a few purposes. The first is 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. Maintaining a manageable franchise tax rate is one reason low par value is preferable.
Most relevant to the work I do with my clients is understanding the restriction preventing the sale of stock for less than its par value. For example, let’s say a founder incorporates 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 that stock purchase 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 potentially losing a percentage of their ownership. Having one million shares keeps the founder in a controlling position while leaving room for more people to acquire 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 stock 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 being awarded stock. At the same time, the value of your stock is increasing. Many founders become concerned when their stock ownership dips below 75%, 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.
Q: How much stock dilution should founders expect?
A: If a founder initially owns 100% of the shares, their ownership will eventually decline to approximately 40% or 50% (if they are lucky) after several rounds of issuing securities. A founder is still unlikely to get outvoted on most issues at that level. One of the services we provide is to help the founders retain voting control even when they don’t have 50%, because every growth company has the goal of partnering and sharing stock with sensible investors.
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 imposing any standardized rule is difficult because every company and every employee is different. Some companies are willing to take a risk on people with less experience. Some founders want to entice hires from large corporations like 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: The main reason for vesting is to protect the company’s equity in the case of an early partner departure. Let’s say you’re a founder and want to bring in a hotshot CTO. You know you must give the CTO stock, but worry 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 your stock value 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 key rule founders need to understand – keep distractions like Board meetings to a minimum so you can focus on getting your product developed and into the market.
Q: What if I still have questions about stock and my startup?
A: At HJF Law, our team of startup experts is here to help. Understanding stock, stock issuance, venture capital investments, stock dilution, and vesting can help guide your early-stage business from incorporation through growth phases and eventually to sale. Visit hjflaw.com/contact and schedule your free consultation to determine if we are the best fit for your startup.