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Tech startup founders strive for and investors appreciate a “clean” capital structure for ventures that will eventually seek outside investment. There are a few terms you will hear when discussing the set-up of the capitalization structure for your business and here is what they mean:
The founders of a startup generally purchase shares at the time of incorporating the company at a nominal price per share, such as $0.0001 per share, paid in cash, since at that time the company will have no operating history, few assets and thus little value. These shares are referred to as founders’ shares.
Founders are the initial group of individuals who conceived the idea and/or the first individuals recruited to get the business off the ground. Founders are usually the one or two individuals who are the driving force behind the startup, but may be a larger group (usually less than six).
The founding group should objectively assess each individual’s expected contribution and allocate founders’ shares on that basis (rather than spread equally across the group). You’ll want to consider whether an initial equity issuance or stock options represents the appropriate incentive for an individual.
A founder may serve as a member of the tech startup’s management team; however, not all members of the management team are founders. Management will likely change over the life of the business and they are usually incented with a combination of cash compensation and stock options.
During start up, entrepreneurs should consider the number of founders’ shares and stock options to be issued in relationship to the current valuation of their business and/or the valuation they hope to achieve in the first round of investment from outside investors.
They need to determine how they wish to allocate the ownership of the business among the founders and to key employees, directors, advisors and contractors.
Consider the example below:
|Shareholder/option holder||Number of shares||Actual percentage owned||Fully diluted percentage|
|Founder A (CEO)||500,000||50%||42.5%|
|Founder B (CTO)||300,000||30%||25.5%|
|Founder C (Key Technical)||200,000||20%||17.0%|
|Issued and outstanding shares||1,000,000||100%||85%|
|Option holder 1||11,765||0%||1.00%|
|Option holder 2||3,000||0%||0.25%|
|Option holder 3||17,650||0%||1.50%|
|Total fully diluted shares||1,176,471||100%||100%|
If the founders had simply issued 50, 30 and 20 shares for a total issued capital of 100 shares instead of 1,000,000, the ownership percentage for the company would remain the same among the founders; however, the company would have difficulty splitting the 17.65 shares available for stock options among option holders, since legally, partial shares are not permitted.
If you have incorporated your business with a smaller than desirable number of shares, you can modify your capital structure by “splitting” the current number of shares issued. You should consult legal counsel who will assist you to seek the necessary shareholder approvals to make the change and to file revised articles of amendment, legally documenting the change.
Tech startup entrepreneurs should seek professional legal advice when setting up or making changes to their capitalization structure, choosing legal counsel with experience in setting up early-stage ventures and working on investment rounds for their clients. Hiring a lawyer may seem like a big expense for your startup, but setting up your business incorrectly will cost you more in the long run.
Houston, Thomas, Andrea Johnson, and Eric Smith. (September 15, 2006). Technology Startups: A Practical Legal Guide for Founders, Executives and Investors. Fraser Milner Casgrain. Retrieved May 21, 2009, from http://www.lexology.com/library/detail.aspx?g=7c476ef3-67a9-4a33-8053-05331cb29e6a.