Once a company has been formed as a corporation and put the right protective agreements in place, one of the next foundational decisions is how to structure its initial equity. How many shares should the company authorize? How should those shares be divided among the founders? And how much equity should be set aside to attract and retain talented employees? These questions do not have a single correct answer, but they follow a logical framework, and decisions made at formation are far easier to get right the first time than to unwind later.
Authorized Shares
When you form a corporation, its certificate of incorporation authorizes the maximum number of shares the company is permitted to issue. This is a ceiling, not a requirement. Many startups, particularly Delaware C corporations, authorize 10 million shares of common stock at formation as a practical starting point.
There is little reason to be stingy at this stage. Authorizing too few shares creates friction later, because increasing the number of authorized shares generally requires board and stockholder approval to amend the certificate of incorporation. That adds cost and administrative burden at exactly the moment you are trying to close a financing or hire a key employee. Authorizing 10 million shares at the outset gives the cap table room to grow with the company.
One important cost consideration for Delaware corporations is the annual franchise tax. Delaware calculates the tax using either the Authorized Shares Method or the Assumed Par Value Capital Method, and a corporation may pay whichever produces the lower amount. Under the Authorized Shares Method, the tax is based solely on the number of shares authorized, regardless of how many have actually been issued. At current rates, a company with 10 million authorized shares would owe $85,165 a year under this method, an unwelcome surprise for many early-stage founders.
Fortunately, most startups can dramatically reduce this bill by using the Assumed Par Value Capital Method, which uses the company’s total gross assets and issued shares to calculate an “assumed par value” that is then applied to its authorized shares. A typical early-stage startup with modest assets will often owe only the $400 minimum under this method, plus the $50 annual report filing fee. The key is knowing to run the calculation: Delaware’s annual franchise tax notice reflects the Authorized Shares Method by default, and founders who simply pay the amount shown can significantly overpay.
Founder Share Allocation
Of the shares authorized at formation, a portion is issued to the founders. Each founder’s initial allocation should reflect their relative contribution to the business, including the original idea, capital contributed, experience and expected future role. Equal splits are common when contributions are roughly balanced, but founders should have an honest conversation about how equity will be divided before anything is documented. Disputes over founder equity are among the most common early-stage conflicts, and they are far easier to resolve before the company has value.
Founder vesting is equally important. Even if you and your co-founders are fully aligned today, we strongly recommend that founder shares be subject to a vesting schedule, often four years with a one-year cliff. For founder shares issued upfront, this typically takes the form of a company repurchase right that lapses as the shares vest. Vesting ensures that a founder who leaves early does not walk away with a large percentage of the company after only a few months of involvement. It protects the remaining team and is commonly expected by institutional investors in a financing round.
Founders receiving restricted stock should also consider whether an election under Section 83(b) of the Internal Revenue Code is appropriate. When applicable, this election generally must be filed with the IRS within 30 days after the stock is transferred. Missing that deadline can have significant tax consequences.
Equity Incentive Pool
Startups often compete for talent against established companies that can offer higher salaries. Equity, in the form of stock options or restricted stock, helps level the playing field. To issue equity to employees or advisors, the company will generally need to adopt a formal equity incentive plan and reserve a pool of shares for that purpose.
For early-stage startups, reserving 10% to 20% of the fully diluted capitalization is a common planning range, although the appropriate percentage varies by company and financing stage. The right size depends on your hiring plans: a company hiring aggressively may need a larger pool, while a leaner team may need less. Keep in mind that venture capital investors typically require an adequate option pool to be in place before a financing round closes. In many venture financings, investors negotiate for the option pool, including any required increase, to be included in the pre-money capitalization. This can increase dilution for existing stockholders rather than the new investors.
A few additional considerations apply when granting options. The exercise price, or strike price, generally must be set at no less than the stock’s fair market value on the date of grant to satisfy applicable tax requirements. Early-stage companies typically support that price with a 409A valuation, an independent appraisal that, under IRS regulations, benefits from a presumption of reasonableness when it meets applicable IRS requirements. Employee vesting schedules often mirror the founder structure of four years with a one-year cliff. Finally, companies must choose between incentive stock options (ISOs) and nonqualified stock options (NSOs). ISOs offer potentially favorable tax treatment but can be granted only to employees and carry strict requirements, while NSOs can be granted to employees, directors, advisors and consultants but are generally taxed as ordinary income when exercised, to the extent the fair market value of the shares exceeds the exercise price.
The Bottom Line
Sophisticated investors scrutinize a company’s capitalization table early in the diligence process. A clean, well-structured cap table, with appropriate founder vesting, a properly sized option pool and no undocumented “handshake” equity promises, signals that the founders have thought carefully about governance and are prepared for a professional investment process. Cleaning up a messy cap table later is possible, but it consumes valuable time and legal fees.
KJK guides startups on structuring their initial equity and administer equity incentive plans to lay the groundwork for successful fundraising. If you are preparing for your first financing round or need assistance with formation, please contact Andrew Wilber (AJW@kjk.com) or Emily Korthaus (ELS@kjk.com).
This is Part III of our “Startups 101” series. Read Startups 101, Part I: Choosing an Entity and State of Formation and Startups 101, Part II: Protecting Confidential Information and Intellectual Property.